10.2 Links between macroeconomic problems and their interrelatedness
- Syllabus
- 9708–2026–2027
- Topic
- 10.2
- Level
- A2
Learning objectives
10.2.1Internal and external money value• Relationship between the internal value of money and the external value of money10.2.2Balance of payments and inflation• Relationship between the balance of payments and inflation10.2.3Growth and inflation• Relationship between growth and inflation10.2.4Growth and balance of payments• Relationship between growth and the balance of payments10.2.5Inflation and unemployment• Relationship between inflation and unemployment:- traditional Phillips curve- expectations-augmented Phillips curve (short- and long-run Phillips curve)
Internal and external money values are distinct but linked in both directions
| Value | Meaning | Direct observation |
|---|---|---|
| Internal value | Domestic purchasing power of one money unit | Inversely related to the domestic price level: inflation lowers purchasing power |
| External value | Purchasing power against foreign currencies | Nominal exchange rate; an appreciation raises and depreciation lowers external value |
| Initial change | Likely link to the other value | Conditions |
|---|---|---|
| Domestic inflation above trading partners | Internal value falls; weaker export competitiveness and greater import demand can reduce currency demand and external value | Exchange-rate regime, elasticities, capital flows and expectations |
| Currency depreciation | External value falls; imported inputs/consumer goods cost more and can cause cost-push inflation, reducing internal value | Import share, pass-through, spare capacity and policy response |
| Lower interest rates or QE | Demand may raise prices while lower relative returns encourage capital outflow/depreciation | Liquidity trap, expectations and other-country policy |
| Productivity/supply improvement | Lower unit costs can support internal value and competitiveness can support external value | Whether gains pass into prices and exports |
If an import-dependent economy's currency depreciates, external value falls immediately. Dearer fuel and raw materials then raise firms' costs and the price level, so internal value also tends to fall. The size and timing are not one-for-one.
The two values can diverge temporarily: a currency may appreciate while domestic inflation continues, or depreciate with little inflation when pass-through is weak. Always name the starting shock and transmission conditions.
Inflation and the balance of payments influence each other through prices, demand and exchange rates
| Starting shock | Causal chain | Likely external result |
|---|---|---|
| Domestic inflation exceeds foreign inflation | Exports become relatively dearer and imports relatively cheaper | Export volume/revenue may weaken and import spending rise, worsening the current account |
| Demand-pull inflation | Strong domestic income raises import demand as well as prices | Current-account deficit may widen, especially near full employment |
| Imported cost-push inflation | Oil/input import bill rises while output and competitiveness weaken | Trade balance, inflation and unemployment can worsen together |
| External development | Route back to the domestic economy | Price effect |
|---|---|---|
| Current-account deficit under a float | Downward currency pressure makes imports dearer | Cost-push inflation, unless weak AD dominates |
| Worsening trade balance under a defended fixed rate | Lower net exports reduces AD; defence may require contraction | Lower output, higher unemployment and weaker demand-pull inflation |
| Export/current-account surplus | Higher net exports raises AD | Demand-pull pressure if spare capacity is low |
| Currency appreciation/capital inflow | Imports become cheaper but net exports may fall | Lower imported inflation; AD effect depends on trade response |
Evaluate with relative—not domestic—prices, PED for exports/imports, import dependence, the exchange-rate regime, spare capacity, capital/primary-income flows and time. A current-account deficit and high inflation may also share a third cause such as excess AD.
The balance of payments is broader than the trade balance, and causation runs both ways. A deficit does not always create inflation: fixed-rate contraction or falling net exports can instead reduce AD and the price level.
Growth and inflation can move together or apart depending on demand and supply
Rapid demand-led growth can raise inflation when output approaches capacity. Productivity-led growth can increase potential output with less price pressure, while a supply shock can create high prices and weak output together.
Use the AD/AS mechanism and the time horizon. Spare capacity, expectations, imported costs and the position of LRAS determine whether more spending changes real output, the price level or both.
A recovery from recession may raise GDP with little inflation; a boom at capacity may raise prices; a technology improvement can raise output while lowering unit costs.
Growth is not automatically inflationary, and low inflation is not proof that growth is sustainable or widely shared.
Growth changes the balance of payments according to its source and financing
| Source/consequence of growth | Current-account route | Wider BOP / feedback |
|---|---|---|
| Higher household income and AD | Import demand rises; current account tends to worsen | Deficit financing can create depreciation pressure |
| Import-intensive capital investment | Machinery/input imports worsen the account initially | Future capacity/export gains may later reverse the effect |
| Productivity or export-led growth | Lower unit costs and greater export capacity can improve goods/services balance | Confidence may attract financial inflows and appreciation |
| Growth raises foreign-investor confidence | No necessary immediate current-account improvement | Financial inflows can reduce a previous overall financing pressure or appreciate the currency |
| External deficit forces contraction | Lower AD can slow growth and imports | Adjustment cost includes unemployment/output loss |
Start by identifying whether growth comes from domestic demand, export demand or productive capacity. Then trace imports, exports, primary income and financial flows separately. Compare short-run import costs with long-run capacity gains.
A construction boom using imported machinery can widen the current account now but raise export capacity later. If strong growth attracts foreign investment, the financial account and currency may strengthen even while the current account remains in deficit.
Do not call every financial inflow an export or assume the current account is the whole balance of payments. A deficit can finance productive investment, but sustainability depends on future returns, financing terms and confidence.
Expectations turn the Phillips trade-off into a short-run relationship
A Phillips curve plots the inflation rate on the vertical axis and unemployment rate on the horizontal axis. The traditional curve shows an inverse empirical relationship: lower unemployment is associated with higher inflation, and vice versa.
| Curve | Shape | What it holds constant | Meaning |
|---|---|---|---|
| Traditional / short-run Phillips curve (SRPC) | Downward sloping | Expected inflation, supply conditions and natural rate | Higher AD can temporarily lower cyclical unemployment while raising inflation |
| Expectations-augmented SRPC | A family of downward curves | Each curve corresponds to one expected inflation rate | Higher expected inflation shifts SRPC upward; worse supply/natural-rate conditions can shift it right |
| Long-run Phillips curve (LRPC) | Vertical at the natural rate / NAIRU | Expectations have fully adjusted | No permanent inflation-unemployment trade-off; demand policy changes inflation, not long-run unemployment |
Adjustment sequence: (1) the economy begins at the natural rate with expected inflation equal to actual inflation; (2) expansionary fiscal or monetary policy raises AD, moving up-left along the current SRPC to lower unemployment and higher actual inflation; (3) workers and firms revise expected inflation upward and negotiate wages/prices; (4) SRPC shifts upward/right; (5) unemployment returns to the natural rate at higher inflation. Repeated attempts to hold unemployment below the natural rate cause accelerating inflation.
| Event | Diagram effect |
|---|---|
| One demand expansion with unchanged expectations | Movement up-left along one SRPC |
| Expected inflation rises after persistent actual inflation | SRPC shifts upward |
| Expected inflation falls | SRPC shifts downward |
| Natural rate rises because of structural mismatch/benefit or labour-market changes | LRPC moves right and SRPC may shift right |
| Adverse supply shock or currency depreciation raising costs | SRPC shifts outward: inflation and unemployment can rise together |
| Productivity/labour-supply improvement | Natural rate/cost pressure may fall; trade-off improves |
For data, a Phillips-consistent movement is inflation rising while unemployment falls, or inflation falling while unemployment rises, over a comparable period. It does not prove causation. Fiscal stimulus is more likely to reduce unemployment temporarily when spare capacity exists; near the natural rate and with adaptive expectations it mainly raises inflation.
There is no permanent menu from which government can choose permanently lower unemployment by accepting steady inflation. Stagflation, global labour supply, union power, migration, productivity, expectations formation and policy credibility can shift or weaken the observed relationship; supply-side capacity measures may improve both inflation and unemployment.