Links Between Macroeconomic Problems (Cambridge (CIE) A Level Economics): Revision Note

The interrelatedness of the objectives

• Macroeconomic objectives are interrelated - pursuing one (e.g. higher growth) often affects others (e.g. inflation, balance of payments)

• Understanding these relationships is essential for evaluating policy trade-offs

• The four key relationships to be aware of are

  • The internal value of money (purchasing power at home) and its external value (exchange rate)

  • The balance of payments and inflation

  • Economic growth and inflation

  • Economic growth and the balance of payments

The internal and external value of money

• The internal value of money is its purchasing power within an economy - what one unit of currency buys domestically

• The external value is its exchange rate against other currencies - what one unit of currency buys in foreign goods

How they are linked

• Inflation reduces the internal value of money - each unit buys fewer goods at home

• High inflation typically reduces the external value of money - foreign demand for the currency falls because domestic goods become more expensive relative to foreign alternatives

• A falling external value (depreciation) raises import prices, which can feed back into domestic inflation, further reducing the internal value

• The two move together over the long run, though short-run movements may diverge due to capital flows and central bank intervention

Implications

• A self-reinforcing cycle can develop in countries with high inflation

  • Falling external value raises imported costs, which raises domestic inflation, which further reduces external value

The balance of payments and inflation

• The balance of payments (BoP) records all economic transactions between a country and the rest of the world

• Inflation affects export competitiveness and import demand, with knock-on effects on the BoP

How they are linked

• Higher domestic inflation makes exports relatively more expensive abroad - export demand falls

• Higher domestic inflation also makes imports relatively cheaper for domestic consumers - import demand rises

• The combined effect is a worsening current account balance - exports fall, imports rise

• A current account deficit may then put downward pressure on the currency, raising import prices, and feeding back into domestic inflation

The reverse direction

• A current account surplus can itself be inflationary - export earnings increase domestic incomes and money supply, raising aggregate demand

• A current account deficit can be deflationary - money flows abroad, contracting domestic demand

Economic growth and inflation

• Economic growth is the increase in real GDP over time

• Whether growth causes inflation depends on whether it is driven by aggregate demand or aggregate supply

When growth causes inflation

• Demand-led growth (rising AD with fixed AS) raises both output and the price level - inflation rises with growth

• This is more likely when the economy is operating near full employment, when AS is steep (close to capacity)

• Strong consumer spending, government stimulus, or low interest rates can all generate this pattern

When growth does not cause inflation

• Supply-led growth (rising LRAS through productivity, investment, technology) raises output without raising prices - inflation may even fall

• Growth driven by improvements in productive capacity expands the economy's potential without increased price pressure

• Examples: technological innovation, infrastructure investment, education and training

The implication for policy

• Growth driven by AD growth requires careful management to prevent overheating

• Growth driven by AS expansion is generally desirable - it raises living standards without inflationary cost

• This is why supply-side policy is often preferred for long-run growth strategy

Economic growth and the balance of payments

• Economic growth typically increases the demand for imports because rising incomes lead to higher consumer spending, including on foreign goods

  • This often worsens the current account balance

The standard relationship

• As real income rises, households consume more goods and services, including imports

• Firms expanding output may import more raw materials, components and capital equipment

• Export growth depends on foreign demand, not domestic conditions - so exports do not automatically rise alongside domestic growth

• The combined effect: rising imports faster than rising exports → worsening current account

Why this is not inevitable

• Export-led growth - countries whose growth is driven by export performance (e.g. Germany, China historically) may grow without worsening their BoP

• Supply-side growth - productivity improvements can make exports more competitive while reducing import dependence

• Income elasticity matters - if a country produces goods with high foreign income elasticity (e.g. luxury exports, high-tech), foreign demand for its exports rises with global growth

The marginal propensity to import

• Countries with a high marginal propensity to import (MPM) see BoP deteriorate quickly with growth

• Countries with a low MPM can grow with less BoP strain

• This depends on industrial structure, trade openness and consumer preferences

How the four relationships interact

• The four relationships are not independent - they reinforce each other

  • Demand-led growth → rising inflation → falling external value of currency → rising imported inflation → worsening BoP

  • Supply-led growth → stable or falling inflation → stable currency → competitive exports → improving BoP