Macroeconomic Policy Conflicts and the Phillips Curve: Question 3

Worked solution

Part (a): How the expansionary fiscal policy is intended to reduce unemployment

Cutting income tax rates raises households’ disposable income, encouraging higher consumer spending, while the increase in infrastructure spending is itself a direct rise in government expenditure ($G$). Both changes raise aggregate demand (with the initial effect on spending reinforced further through the multiplier process). As firms across the economy face higher demand for their output, they respond by producing more and hiring additional workers to do so. This additional demand for labour reduces demand-deficient (cyclical) unemployment, moving Meridia’s unemployment rate closer to its target.

Part (b): Two policy conflicts this expansionary fiscal policy could create

Conflict with low inflation. As aggregate demand rises towards (or beyond) Meridia’s productive capacity, firms find it increasingly difficult to raise output further without bidding up the price of scarce factors of production. The resulting excess demand for goods and services generates demand-pull inflation, conflicting directly with the objective of low, stable inflation. This is exactly the short-run Phillips curve trade-off between lower unemployment and higher inflation.

Conflict with a sustainable current account. The tax cut raises households’ disposable income, and part of this extra income is typically spent on imported goods and services. Infrastructure projects may also require imported machinery, materials or expertise. Because import spending rises while export earnings are not directly boosted by the policy, the current account balance is likely to deteriorate, conflicting with the objective of a sustainable current account of the balance of payments.

Part (c): How a supply-side policy could reduce the inflation-unemployment conflict

A supply-side policy, such as government-funded retraining and skills programmes targeted at Meridia’s unemployed workers, aims to reduce structural and frictional unemployment by making unemployed workers more employable in growing sectors, and to raise the economy’s underlying productive capacity by expanding the effective labour supply. Because this policy works by improving the supply side of the economy (shifting long-run aggregate supply and lowering the natural rate of unemployment) rather than by adding to aggregate demand, unemployment can fall without generating the same demand-pull inflationary pressure that comes from a purely demand-side expansion. This means Meridia’s government can reduce unemployment while facing a smaller conflict with its low-inflation objective than if it relied on fiscal or monetary stimulus alone.

Final answers

• (a) Tax cuts and higher government spending raise aggregate demand, so firms hire more workers and demand-deficient unemployment falls
• (b) Demand-pull inflation (AD rising towards capacity) and a worsening current account (higher import spending from higher disposable income)
• (c) Supply-side policy (e.g. retraining) reduces unemployment by improving the supply side and lowering the natural rate, without relying on the demand-pull pressure that causes the inflation conflict