AQA A-level Economics: Conflicts between macroeconomic objectives and the Phillips curve (7136)

This guide is aligned to the AQA AS and A-level Economics specification (7135 and 7136), version 1.3. It covers the sub-section “Possible conflicts between macroeconomic policy objectives”, printed as 4.2.3.4 in the combined PDF and numbered 3.2.3 on the AQA website and this site’s map. It is part of the A-level content on Economic performance, assessed in Paper 2 (National and international economy), and Paper 3 assesses all content. The specification gives no AS-only or A-level-only labels inside this section. Every country, firm and figure below is invented for illustration.

Related pages: the AQA A-level Economics hub, the printable checklist, the revision notes, the practice set, the AD/AS guide and the free diagnostics.

What the specification asks for

Specification point	You must be able to
Output gaps	Link negative and positive output gaps to unemployment and inflationary pressure
Phillips curves	Explain the short-run Phillips curve and the long-run, L-shaped (vertical) Phillips curve
Implications	Say what each curve means for policy
Reconciling conflicts	Discuss policies for short-run and long-run conflicts, using AD/AS
Long-run view	Discuss the monetarist/supply-side view that the main objectives are compatible in the long run

1. Output gaps, unemployment and inflation

The output gap is the difference between actual output and potential output (the level the economy can sustain without building inflationary pressure).

output gap (%) = (actual output − potential output) / potential output × 100

• A negative output gap (actual below potential) means spare capacity. Firms hire less, so cyclical (demand-deficient) unemployment is high. Weak demand and slack labour markets mean little pressure on wages and prices, so inflation is low or falling.
• A positive output gap (actual above potential) means demand is stretching capacity. Labour is scarce, wages are bid up, firms raise prices, so unemployment is low and inflationary pressure is strong.

Worked example 1. Country P has potential output of 800 (illustrative units). The table shows four years.

Year	Actual output	Output gap	Unemployment (%)	Inflation (%)
1	760	(760 − 800)/800 = −5.0%	8.0	1.0
2	784	−2.0%	7.0	1.8
3	800	0.0%	6.0	2.5
4	832	+4.0%	4.5	4.2

As the gap moves from negative to positive, unemployment falls and inflation rises. Unemployment fell 1.0, 1.0 and 1.5 points; inflation rose 0.8, 0.7 and 1.7 points. Inflation accelerates once the gap is positive.

Caution. Potential output cannot be observed. It is estimated, so the size, and even the sign, of a gap is uncertain. Policy based on a wrong estimate can overheat or under-use the economy.

2. Why objectives can conflict

The main objectives are economic growth, price stability, low unemployment and a stable current account balance. Governments may also pursue a balanced budget and an equitable distribution of income, and the weight placed on each changes over time. Conflicts arise, at least in the short run, because one policy move helps one objective and hurts another.

Demand-led growth against inflation and the current account. A rise in AD moves the economy up the short-run AS curve: output rises and unemployment falls, but the price level rises. If it pushes output beyond potential, inflation accelerates. Higher incomes also raise imports.

Worked example 2. In Country R, GDP is 1,000 and the current account deficit is 10. GDP grows by 40 (4.0%). The marginal propensity to import is 0.3, so imports rise by 0.3 × 40 = 12. Exports rise by 5 because partner demand grows. The net change is 5 − 12 = −7, so the deficit becomes 17. As a share of the new GDP of 1,040 it rises from 1.0% to 1.63%.

Supply shocks. A cost-push shock shifts short-run AS to the left. Take Country Q: the price level index rises from 120 to 126, a rise of 6/120 × 100 = 5.0%. Real output falls from 600 to 582, a change of −3.0%, and unemployment rises. Inflation and unemployment worsen together (stagflation), and no change in AD can fix both: raising AD restores output but lifts prices further; cutting AD lowers prices but deepens the output loss.

3. The short-run Phillips curve

The short-run Phillips curve (SRPC) shows an inverse relationship between unemployment (horizontal axis) and inflation (vertical axis). It slopes down and is steeper at low unemployment. It is the output-gap link in section 1 drawn as a trade-off: lower unemployment is bought with higher inflation.

Worked example 3. Country K, illustrative points on one SRPC:

Unemployment (%)	3.5	4.5	6.0	8.5
Inflation (%)	6.5	4.0	2.5	1.5

inflation %
6.5 |*
4.0 |    *
2.5 |          *
1.5 |                     *
    +--3.5--4.5----6.0------8.5-- unemployment %

Cutting unemployment from 4.5% to 3.5% costs 6.5 − 4.0 = 2.5 points of inflation, so 2.5 per point. From 6.0% to 4.5% it costs 1.5 points over 1.5 points, so 1.0 per point. From 8.5% to 6.0% inflation rises 1.0 over 2.5 points, so 0.4 per point. The trade-off worsens as unemployment falls, which fits an economy where labour becomes scarce.

Policy implication. A government can choose a point on the curve, but not escape it: lower unemployment means accepting higher inflation, and an inflation target means accepting some unemployment.

Shifts. The SRPC moves outward (up and right) when short-run AS shifts left through cost-push shocks, or when expected inflation rises, because workers then bargain for bigger wage rises. It moves inward when productivity growth is faster or expectations fall. Stagflation is a shift of the curve, not a movement along it.

4. The long-run, L-shaped Phillips curve

The specification calls this the L-shaped Phillips curve and says it is also known as the vertical long-run Phillips curve. Draw a vertical line at the long-run (natural) rate of unemployment. Whatever the inflation rate, unemployment returns to that rate once expectations have caught up.

The argument is as follows. Suppose AD rises when unemployment is at its long-run rate. Output and employment rise and unemployment falls below that rate. Workers see their real wages eroded when prices rise faster than expected, and later demand compensation. Wages rise, costs rise, short-run AS shifts left, and output and unemployment return to their earlier levels at a higher price level. The economy has moved to a higher SRPC. The long-run supply of output is fixed by supply-side factors, so AD changes alter the price level, not real output.

Worked example 4: holding unemployment below the long-run rate. Assume the SRPC is inflation = expected inflation − 0.5 × (unemployment − 6), with a long-run rate of 6%, and workers expect last year’s inflation. Starting at 2% expected inflation, the government targets 4.5% unemployment.

Year	Expected inflation (%)	Actual inflation (%)
1	2.00	2 − 0.5 × (4.5 − 6) = 2.75
2	2.75	3.50
3	3.50	4.25
4	4.25	5.00

Each year inflation rises by 0.75 points. Keeping unemployment below the long-run rate needs ever-faster inflation, so there is no permanent trade-off.

Worked example 5: cutting inflation. Using the same curve, inflation is 8%, expected inflation is 8%, and the government tightens policy to hold unemployment at 10%. Year 1: 8 − 0.5 × (10 − 6) = 6. Year 2: 6 − 2 = 4. Year 3: 4 − 2 = 2. That costs 4 points of excess unemployment for three years, 12 point-years, or 12/6 = 2 point-years per point of inflation removed. If a credible announcement cut expectations to 4% at the start, year 1 would give 4 − 2 = 2%. The cost would be 4 point-years, about 0.67 per point. Credibility lowers the price of disinflation.

5. Policy implications and reconciling conflicts

Short run. Demand management moves the economy along an SRPC.

• Negative output gap: expansionary fiscal or monetary policy raises AD, and unemployment falls with little inflation cost because there is slack.
• Positive gap: tighter policy cools demand and reduces inflationary pressure at the cost of output and jobs.
• Stagflation: demand policy cannot fix both problems. Governments must choose between them or use supply-side measures.

Worked example 6. Country P’s year 1 gap is −40 (−5.0% of 800). With a multiplier of 1.6 (given), the injection needed is 40/1.6 = 25. If potential output is really 780, the true gap is (760 − 780)/780 = −2.56%. The same 25 raises output by 25 × 1.6 = 40, to 800, which is 2.56% above potential: the cure has caused a positive gap and inflationary pressure.

Long run. The main lever is the supply side. Policies that raise productivity or cut structural unemployment (training, incentives, competition, labour-market reforms) shift long-run AS to the right and move the vertical Phillips curve to the left. Both move the economy to a better position: more output and lower unemployment without extra inflation.

Worked example 7. Suppose potential output rises from 800 to 824 (+3.0%). Suppose also that the long-run unemployment rate falls from 6% to 5%. With expected inflation at 2%, the new curve is inflation = 2 − 0.5 × (u − 5). At 5% unemployment inflation was 2.5% on the old curve and is now 2.0%. At 2% inflation unemployment is now 5%, not 6%.

6. The monetarist/supply-side view

Monetarist and supply-side economists argue that in the long run the objectives are compatible.

• Long-run output and the long-run rate of unemployment are set by supply-side factors, not by AD.
• Low, stable inflation, secured by a credible, rules-based approach to money and demand, removes uncertainty. That encourages saving, investment and efficient pricing, which raise the growth of long-run AS.
• Supply-side growth reduces unemployment, and competitiveness helps the current account.

Evaluation.

• Keynesian critics say the long run can be very long. Wages and prices are sticky, so a deep negative gap can persist.
• Long spells of unemployment can erode skills, which may raise the long-run rate (the vertical curve shifts right) so that demand policy affects the long run too.
• Supply-side policies are slow, uncertain and can widen inequality, which is itself an objective.
• The view works best for demand-pull inflation; for cost-push and external shocks, short-run conflicts remain.
• Evidence matters: ask whether a country’s data lie on one curve or several.

Common errors

• Plotting unemployment on the vertical axis.
• Treating the SRPC as a permanent menu of choices.
• Calling a shift of the curve a movement along it.
• Drawing the long-run curve at zero unemployment.
• Stating the output gap without dividing by potential output.
• Offering demand policy as the cure for stagflation without commenting on the trade-off.

Official syllabus

AQA AS and A-level Economics (7135 and 7136), specification for first teaching from September 2015, version 1.3, 29 June 2022, published by AQA. Combined PDF section 4.2.3.4, Possible conflicts between macroeconomic policy objectives.