Macroeconomic Policy Conflicts and the Phillips Curve: Question 9

Worked solution

Part (a): Why raising interest rates increases unemployment

Raising interest rates increases the cost of borrowing for households and firms while making saving more attractive, so consumption and investment spending both fall. This reduces aggregate demand across Doverath’s economy. Facing weaker demand for their output, firms produce less and reduce their demand for labour, including through redundancies, so unemployment rises.

In terms of the short-run Phillips curve, this is a movement along the existing curve, not a shift of it: the same demand-side channel that lowers inflation (by easing pressure on prices as aggregate demand falls) simultaneously moves the economy to a point on the curve with higher unemployment, illustrating the standard short-run trade-off between the two objectives.

Part (b): Does the resulting appreciation add further conflicts?

The case that appreciation adds real conflicts. Higher interest rates make Doverath’s financial assets more attractive to foreign investors seeking a better return, so foreign financial capital flows in, raising demand for Doverath’s currency and pushing its exchange rate up. This appreciation makes Doverath’s exports more expensive in foreign-currency terms and makes imports cheaper in Doverath’s own currency. Assuming demand for exports and imports is reasonably price-responsive (the Marshall-Lerner condition), export volumes are likely to fall and import volumes to rise. This reduces net exports ($X-M$), which both slows growth (adding a second channel, alongside higher interest rates themselves, through which aggregate demand and output are squeezed) and worsens the current account balance, since export revenue falls relative to import spending. Weaker export demand may also add to job losses concentrated in exporting industries, compounding the unemployment rise identified in part (a).

Reasons the extent of the conflict is uncertain. Several factors limit or complicate this conclusion. First, the size of the fall in net exports depends on how responsive trade volumes actually are to the price changes; if demand for Doverath’s exports and for imports is relatively price-inelastic, the appreciation may barely affect trade volumes, and the current account could even improve in the short run before volumes adjust (the J-curve effect). Second, the same appreciation that squeezes exports also makes imports cheaper, which reinforces rather than conflicts with the original policy goal of lower inflation, since cheaper imported goods and inputs directly ease cost-push pressures. Third, the ultimate size of the appreciation depends on how much of the interest rate rise is expected to persist and on conditions in other countries, which are outside the central bank’s control.

Overall judgement. Raising interest rates to control inflation is likely to create a genuine additional conflict with growth and the current account through the exchange rate channel, on top of the direct rise in unemployment, but the extent of this conflict is uncertain, depends on the price-responsiveness of trade flows and on time lags, and is partly offset by the disinflationary benefit of cheaper imports. This means monetary policy alone rarely achieves lower inflation without meaningful costs elsewhere in the economy.

Final answers

• (a) Higher interest rates cut spending, lowering aggregate demand and output, so the economy moves along the short-run Phillips curve to lower inflation but higher unemployment
• (b) The resulting appreciation likely reduces net exports, adding conflicts with growth and the current account, but the extent is uncertain (depends on trade-volume responsiveness and lags) and partly offset by cheaper imports reinforcing lower inflation