Activity 9(c)

Activity 9c: Managing the trade-off between inflation and economic growth/employment

  1. Any attempts to reduce the rate of inflation and therefore achieve price stability will involve a trade-off in terms of the negative impact on economic growth. Alternatively, any attempt to stimulate economic growth will involve a trade-off in terms of an increase in the rate of inflation.


  1. A more expansionary monetary policy stance and the accompanying lower interest rates is likely to contribute to a stronger rate of economic growth which therefore leads to an increase in the rate of inflation as demand inflationary pressures begin to build in the economy.


  1. In contrast, a more restrictive monetary policy stance (evidenced by higher interest rates) is likely to help with the achievement of price stability as the higher interest rates will reduce demand inflationary pressures. However, by reducing aggregate demand it should contribute to a lower rate of economic growth.


  1. This is because the rate of growth in output over time (or in the long run) ultimately depends on the ability of the economy’s resources to produce goods and services. In other words, it depends on the productive capacity of the economy and/or the growth in the economy’s ability to supply goods and services (i.e. aggregate supply).  As capacity utilization rates rise to higher and higher levels, it indicates that lower levels of spare capacity exist in the economy, which leads to an increase in inflationary pressures.  This signals to the RBA that it will need to be more aggressive in its tightening of policy in order to contain inflationary pressures.


  1. This is because continual efforts to exploit the nature of the trade-off will lead to an ongoing imbalance between (aggregate) demand and (aggregate) supply levels in the economy, with the growth in AD outpacing the growth in AS such that prices (or inflation) must increase. To stimulate growth in the long run, the economy also requires an increase in reductive capacity or AS.


  1. Simply because it will add to inflationary pressures which makes growth less sustainable in the long run.


  1. Economic growth can only be stimulated in the long run via effective implementation of aggregate supply policies that are designed to boost the nation’s productive capacity. Monetary policy can and does play a role to stabilise the business cycle over the short to medium term and ensure that inflation is kept low enough to maintain competitiveness and therefore provide an economic climate that is conducive to continuing investment and growth in supply potential over time.