10.2 Links between macroeconomic problems and their interrelatedness

The internal value of money is its purchasing power over domestic goods and services, which falls as the price level rises. The external value is the currency’s exchange rate against other currencies.

A currency can depreciate externally and still have stable internal purchasing power, or it can appreciate while domestic inflation erodes real value. Imported prices, interest expectations and capital flows link the two but do not make them identical.

If a currency falls 10% against the dollar, imported fuel may become dearer and raise domestic prices, but the size of the internal effect depends on pass-through and the share of imports.

A “strong currency” can refer to an exchange rate or domestic purchasing power; name which one is meant.

If domestic inflation is higher than trading partners’ inflation, domestic goods may become less competitive, while imports become relatively attractive, tending to weaken the trade balance if quantities respond.

The effect depends on the exchange rate, quality, contracts, import content, demand elasticities and the time horizon. Inflation caused by a depreciation may be accompanied by an initial trade-balance worsening before quantities adjust.

A 6% domestic inflation rate against 2% abroad can make exports relatively expensive, but a productivity gain or currency depreciation may offset part of that loss.

Higher inflation does not mechanically cause a current-account deficit; relative prices, quantities and income flows all matter.

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 can affect the balance of payments by raising import demand, changing competitiveness and attracting or generating capital flows. The direction depends on the source and composition of growth.

Demand-led growth often increases imports as incomes rise; productivity-led export growth may improve the current account. An appreciating currency or high import content can offset the benefit.

A construction boom that relies on imported machinery may widen the current-account deficit, while export-sector productivity growth can raise foreign receipts without the same import surge.

A growing economy does not automatically improve its external balance, and a deficit is not necessarily unsustainable if it finances productive investment.

A demand expansion may reduce cyclical unemployment while increasing inflation when spare capacity narrows. Supply shocks can raise inflation and unemployment together, producing stagflation.

Expectations, labour-market structure and the time horizon matter. A long-run trade-off is not guaranteed: once expected inflation adjusts, unemployment may return toward its natural rate.

A stimulus during a recession can bring idle workers back without much initial price pressure; an energy shock can then raise prices while firms cut output and jobs.

The Phillips-curve idea is not a permanent menu of inflation for unemployment, and correlation does not identify the policy cause.