OCR A Level Economics: Policy conflicts and the evolution of macroeconomic policy (H460)

This guide covers two topics from the area of study “The application of policy instruments” (Component 2, Macroeconomics) in the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021: Policy conflicts and Approaches to policy and macroeconomic context. The specification does not label this content by level. Component 03 is synoptic, so these ideas can also be drawn on there.

Related pages: the OCR Economics hub, the checklist, the revision notes, the practice questions, the Phillips Curve and schools of thought guide and the free diagnostics. All countries and figures below are made up.

What you must be able to do

Specification point	In practice
Explain trade-offs between objectives: unemployment and inflation; growth and inflation; inflation and the balance of payments; growth and the balance of payments; growth and income and wealth equality	Give a causal chain for each
Evaluate the consequences of conflicts	Say who gains, who loses and by how much
Evaluate methods of resolving or reducing conflicts	Judge each method on cost, time and conditions
Evaluate debates on price and wage flexibility, flexibility/elasticity of aggregate supply, and expectations	Set out both sides, then decide when each holds
Explain why approaches change: the Great Depression, Keynesian demand management in the 1970s, monetarism in the 1980s, the 2007-08 crisis and aftermath	Link each shift to its cause

1. Why objectives conflict

A policy instrument aimed at one objective usually moves other variables as well. Conflicts are strongest near full capacity and weakest with spare capacity. State which you assume.

Unemployment and inflation

Chain: demand-side stimulus, so AD rises, so firms hire, so unemployment falls, so labour is scarcer, so wage growth and inflation rise. The short-run Phillips Curve captures this. Worked example 1 (Country A, illustrative). Points on a short-run curve: unemployment 8% gives inflation 1.0%; 7% gives 1.8%; 6% gives 2.9%; 5% gives 4.4%. The labour force is 25 million.

• Moving from 6% to 5% unemployment adds 4.4 − 2.9 = 1.5 points of inflation and employs 1% × 25 million = 250,000 more people.
• Cutting inflation back from 4.4% to 2.9% means accepting 6% unemployment: 250,000 jobs for 1.5 points, about 166,667 jobs per point of inflation.
• A cost shock lifts inflation by 1.5 points at every unemployment rate. To get back to 2.9% you need the old curve to read 1.4%. That lies between 8% (1.0) and 7% (1.8): 7 + (1.8 − 1.4) ÷ (1.8 − 1.0) = 7.5%. Unemployment must reach 7.5%, which is 375,000 more unemployed than at 6%.

The trade-off worsens after a supply shock. It may vanish in the long run if expectations adjust.

Growth and inflation

Chain: faster AD-led growth, so spare capacity is used up, so costs and bottlenecks rise, so the price level rises.

Worked example 2 (Country B). Output is 480 and potential output is 500, a gap of −4.0%. The government injects 18. With a multiplier of 2, output rises by 36 to 516, which is 16 (3.2%) above potential. The extra demand cannot be met and prices rise. An injection of 20 ÷ 2 = 10 would close the gap exactly. The conflict appears only once spare capacity is gone.

Inflation and the balance of payments

Chain: higher domestic inflation than competitors, so exports are dearer abroad and imports are cheaper at home, so the current account worsens. A floating currency should depreciate to offset this. A fixed rate cannot.

Worked example 3 (Country C). The currency buys 2.00 units of foreign money. Domestic prices rise 6% and foreign prices 2%, with the nominal rate unchanged. The real exchange rate rises by 1.06 ÷ 1.02 − 1 = 3.9%, so Country C’s goods are 3.9% dearer relative to foreign goods. To restore competitiveness the nominal rate would have to fall to 2.00 ÷ 1.0392 = 1.925.

Growth and the balance of payments

Chain: rising incomes, so spending on imports rises with the marginal propensity to import, so the current account worsens unless exports grow as fast.

Worked example 4 (Country D). GDP is 800, the marginal propensity to import is 0.35 and the current account deficit is 16 (2.0% of GDP). GDP grows 3%, so rises by 24. Imports rise by 0.35 × 24 = 8.4. Exports rise by 3 because trading partners grow. The deficit becomes 16 + 8.4 − 3 = 21.4, which is 21.4 ÷ 824 = 2.6% of GDP. The rise in GDP that exports alone could pay for is 3 ÷ 0.35 = 8.57, or 1.07%.

Growth and income and wealth equality

Chain: if growth is led by a few high-skill or capital-heavy sectors, top earners gain first, and asset owners gain as asset prices rise, so inequality widens. It is not automatic. Broad-based growth in jobs and wages can narrow inequality.

Worked example 5 (Country E). Three groups: the bottom 40% of people with average income 8,000, the middle 50% with 22,000, the top 10% with 90,000. Mean income = 0.4 × 8,000 + 0.5 × 22,000 + 0.1 × 90,000 = 23,200. Incomes then grow 1%, 3% and 7%. New means: 8,080, 22,660 and 96,300, so the national mean is 24,192, growth of 4.3%. The top 10% share rises from 38.8% to 39.8%; the bottom 40% falls from 13.8% to 13.4%. Absolute gains are 80 and 6,300. Growth was strong, yet the gap widened.

2. Consequences and resolution

Consequences depend on which objective is sacrificed:

• Accepting higher unemployment to cut inflation means lost output, lost incomes, and possible hysteresis if long-term unemployment erodes skills.
• Accepting higher inflation to protect jobs hurts savers and fixed-income groups, and may lower competitiveness.
• A persistent external deficit must be financed by borrowing or asset sales.
• Rising inequality can cut social mobility and slow growth if poorer households underinvest in education.

Methods of resolving or reducing conflicts:

Method	How it helps	Limits
Supply-side policy (training, investment, competition)	Shifts long-run AS right, so growth comes with lower inflation, lower natural unemployment and better competitiveness	Slow, costly, uncertain; gains may be uneven
Policy mix (for example tighter money with targeted fiscal support)	More instruments than targets lets policy aim at each objective	Instruments interact; coordination needed
Prioritising one objective	Clear and transparent, for example an inflation target	The sacrificed objective suffers
Exchange rate adjustment	Depreciation eases an external deficit	Raises import prices; Marshall-Lerner condition needed
Redistribution through tax and benefits, or targeted education	Offsets inequality from growth	May weaken incentives; funding costs
Timing	Stimulate when there is spare capacity; tighten near capacity	Lags and poor data on the output gap

Evaluation: judge by the starting position (spare capacity or not), the source of the problem (demand or supply shock), the time horizon and who bears the cost. Supply-side measures reduce conflicts most in the long run but give little relief in a short inflation spell.

3. Debates in macroeconomic thinking

Flexibility of prices and wages

If wages and prices adjust quickly, markets clear and unemployment is temporary. If they are sticky, demand shocks cause lasting unemployment.

Worked example 6. Labour demand is L = 14 − 0.4w and labour supply L = 4 + 0.6w (millions; w in currency units per hour). Equilibrium: 14 − 0.4w = 4 + 0.6w, so w = 10 and L = 10. Demand falls to L = 12.4 − 0.4w.

• If wages are flexible: w = 8.4, L = 9.04. Pay falls 16% and employment 9.6%.
• If wages stay at 10: demand is 8.4 but supply is 10, so 1.6 million are unemployed.

Keynesians argue that sticky wages are real, and that big pay cuts also cut spending, so demand falls further. Neo-classical economists argue that flexibility, helped by labour market reform, speeds recovery. Wages are often stickier downwards than upwards, but adjustment can come through hours and bonuses.

Flexibility and elasticity of aggregate supply

The slope of AS determines whether an AD change shows up in output or prices. Using nominal AD growth ≈ output growth + price growth, with elasticity e = output change ÷ price change:

Worked example 7. Nominal AD rises 5%. Price change ≈ 5 ÷ (1 + e), output change ≈ 5e ÷ (1 + e).

e	Price change	Output change
4.0 (spare capacity)	1.0%	4.0%
1.0	2.5%	2.5%
0.25 (near capacity)	4.0%	1.0%

Neo-classical analysis sees long-run AS as steep or vertical; Keynesian analysis sees it as flat at low output. Spare capacity and supply-side policy make AS more elastic.

The role of expectations

Expectations affect wage bargaining, pricing and real interest rates. Under adaptive expectations people extrapolate from past inflation. Under rational expectations they use all available information, including announced policy, so credible policy changes behaviour quickly.

Worked example 8. A nominal interest rate of 4% with expected inflation of 2% gives a real rate of 1.04 ÷ 1.02 − 1 = 1.96%. If expected inflation rises to 5%, the real rate is 1.04 ÷ 1.05 − 1 = −0.95%. The same interest rate now stimulates instead of restrains. Policy outcomes depend on what people expect, and this is why credibility matters.

4. Why approaches change

Each shift followed a failure of the previous approach to deal with events.

• The Great Depression. After 1929, output and prices fell sharply in many countries, with mass unemployment. The prevailing view was that falling wages and prices would restore full employment. They did not. Keynes argued that deficient AD could hold an economy in equilibrium below full employment, and that governments should act. Illustration: a 30% fall in output needs a 100 ÷ 70 − 1 = 42.9% rise to recover. With debts fixed in money terms and prices down 20%, a debt of 100 is worth 100 ÷ 0.8 = 125 in real terms, which deepens the slump.
• Keynesian demand management in the 1970s. After the war, governments used AD to maintain full employment. In the 1970s oil price rises and strong wage claims raised costs and inflation while unemployment also rose (stagflation). Worked example 9: money wages rise 11% with inflation at 9% and productivity up 0.5%. Real wages rise 1.8% and unit labour costs 1.11 ÷ 1.005 − 1 = 10.5%. Expanding AD to cut unemployment fed inflation, and the Phillips Curve trade-off seemed to break down.
• The monetarist approach in the 1980s. Monetarists stressed expectations, the natural rate of unemployment, control of money supply growth, and supply-side reform. From MV = PY with V constant, money growth of 9% and real output growth of 2% imply inflation of 1.09 ÷ 1.02 − 1 = 6.9%. Cutting money growth to 5% implies 2.9%. Weakness: if velocity falls 2% a year, 5% money growth gives only 0.9% inflation, so targets proved unreliable; and in some countries high interest rates deepened recession.
• The 2007-08 financial crisis and aftermath. Bank losses on lending, shown by a bank with assets of 100 and equity of 4: a 5% fall in asset values costs 5, wiping out equity. The failure of a large US investment bank in 2008 spread fear and cut credit. Central banks cut policy rates to very low levels and used quantitative easing; many governments first supported demand, then consolidated budgets. Worked example 10: cutting spending by 20 with a multiplier of 1.5 would reduce output by 30. Regulation of bank capital tightened. The period reopened debate about stimulus versus consolidation and financial stability.

Common errors

• Describing a trade-off without saying whether there is spare capacity.
• Listing history without linking cause to the change in approach.
• Saying “supply-side policy solves everything” without time lags and costs.

Official syllabus

OCR, A Level in Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. Topics: Policy conflicts; Approaches to policy and macroeconomic context.