Economic trade-offs

Readers Question Q) evaluate the view that ‘trade-offs will be required over the period of the economic cycle’?

Economic trade-offs are an important economic concept. They are related to that of opportunity cost.

This PPF curve shows a simple economy with two choices – capital goods or consumer goods. If we increase capital goods(more investment), the trade off is that there will be a decline in consumer goods. (at least in the short-term)

We could also show a trade off between military spending and health care spending. Every element of government spending will have a trade off. If the government increase spending on health care, the trade off will be higher taxes, higher borrowing or cutting other forms of spending.

Individual Trade-offs

This shows the individual trade-off people face. If you spend an extra two hours of leisure, that is two hours less of work.

Trade-off During Macroeconomic cycle

In the economic cycle, there are often trade-offs between different macroeconomic objectives. For example, if an economy achieves higher economic growth, the trade-off might be more inflation, more imports and higher levels of pollution.

The main macroeconomic trade-offs include

• Higher economic growth vs higher inflation
• Higher growth vs current account deficit
• Unemployment vs Inflation
• Economic growth vs Environment

For example, if the government attempts to increase AD by implementing expansionary fiscal policy, we will get an increase in real GDP and therefore lower unemployment, but at the cost of higher inflation.

Diagram of Economic Growth

This is an example of a trade-off between economic growth + unemployment vs inflation.

The tradeoff can be shown with a Phillips curve

However, not all economists believe there is a trade-off. Monetarists believe LRAS is inelastic therefore in the long term there is no trade-off.

Economic growth without a trade-off of inflation

Also, through supply-side policies, you can reduce unemployment and increase economic growth without causing inflation.

Also, in the right circumstances, you can reduce both unemployment and inflation. For example, successful supply-side policies which increase economic efficiency.

Full List of potential Macro Trade-offs

Austerity vs Lower short-run Growth

Austerity is the policy of reducing government borrowing. It requires higher taxes and or lower government spending. This improve the government’s budget deficit. But, in the short-run, it will lead to lower aggregate demand and a fall in real GDP.

The impact of austerity will depend on the state of the economy. For example, in a recession, a cut in government spending will make the recession worse, because demand is already falling. It also depends on whether anything is helping to boost demand. For example, if the government increase taxes, but the Central Bank cuts interest rates this will help to offset the fall in AD from austerity.

See more on austerity

Exchange rate stability vs economic growth

At certain times, keeping the value of the exchange rate fixed can causes costs – if the fixed exchange rate is overvalued. If the exchange rate is overvalued and the currency falling below its particular target zone, then the government will be forced to intervene – through increasing interest rates and/or buying currency.

However, although this will keep the exchange rate within its target zone, there will be trade-off

• Higher interest rates will lead to increased cost of borrowing and lower investment and economic growth.
• The overvalued exchange rates will make exports more expensive, and cause relatively lower demand for exports.

Example – UK in ERM

A good example is the experience of the UK in the exchange rate mechanism 1990-92. The government wanted to maintain a strong exchange rate. However, there was a cost of lower economic growth (interest rates too high) and a fall in exports.

See – UK in exchange rate mechanism

Economic growth vs Environment

Another perspective is to consider the trade-off between economic growth (increasing GDP) and the effect on the environment and living standards.

Higher growth which causes higher output can lead to increased pollution and use of non-renewable resources (such as water). This is an environmental cost – which may have long-term implications.

However, economic growth doesn’t have to damage the environment. Economic growth which incorporates renewable energy and limits pollution.

This trade-off can be explored with the Environmental Kuznets Curve.

Related

• Monetarist view of Phillips Curve
• Trade-offs between Unemployment and inflation

About The Author

Tejvan Pettinger

Tejvan Pettinger. Author of “Cracking Economics” “What Would Keynes Do?” – studied PPE Oxford University (1995-99) and works as an economics teacher and writer.

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