Discuss the potential conflicts between macroeconomic objectives when the central bank attempts to control inflation

Edexcel A-Level Economics Paper 2 June 2019 Extract

With reference to Extract C, discuss the potential conflicts between macroeconomic objectives when the central bank attempts to control inflation. (12 marks)

Extract c line 15 mentions concerns of 'rising inflation'. The central bank are likely to respond with higher interest rates to control this, since the inflation target is around 2%.

The first possible conflict is an increase in unemployment. As interest rates increase, the cost of borrowing and the reward for saving both increase. This incentivises consumers to borrow less and save more. For example, people might become less likely to take out a mortgage and buy a house at this point in time. This can also cause a negative wealth effect as house prices fall due to a fall in demand. Therefore, consumer confidence and consumer spending fall, so aggregate demand falls. This causes a fall in real gdp, as less goods and services need to be produced. Therefore there will be less derived demand for labour, which would cause cyclical unemployment to increase.

Secondly, higher interest rates could cause the current account deficit to worsen. The UK's current account deficit has recently been between 2 and 3% of GDP. As the central bank raises interest rates, this causes an overall flow of hot money into the UK as people want to take advantage of a better return on savings in comparison to other countries. This causes an increase in demand for the pound, causing it to appreciate. Figure 1 mentions £1 was just under $1.30 around May 2017. A further appreciation makes imports cheaper and exports more expensive, so the UK's current account deficit could worsen.

Despite the Philips curve explaining the theory behind this, the extract explains that the UK 'recorded the lowest rate of unemployment since 1975'. One explanation of this could be the state of the economy. If the economy was previously experiencing a positive output gap, this would mean that the actual growth rate was faster than the potential growth rate, which would mean that aggregate demand could fall, and the price level could fall, without having a significant impact on real gdp or the unemployment rate.

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