Links Between Macroeconomic Problems And Their Interrelatedness (Copy)
10.2.1 Relationship Between the Internal Value of Money and the External Value of Money
- Internal Value of Money:
- Refers to the purchasing power of money within a country, mainly determined by domestic price levels (inflation).
- If inflation rises, internal value of money falls (money buys fewer goods).
- External Value of Money:
- Refers to the exchange rate or the value of a country’s currency relative to other currencies.
- Affects import/export competitiveness and capital flows.
- Link:
- High domestic inflation tends to depreciate the currency externally as domestic goods become relatively more expensive, reducing demand for the currency.
- Conversely, a strong external value often supports low internal inflation.
10.2.2 Relationship Between the Balance of Payments and Inflation
- Balance of Payments (BoP): Records all transactions between a country and the rest of the world.
- Inflation Impact on BoP:
- High domestic inflation makes exports less competitive abroad → worsening trade balance (deficit).
- Imports become relatively cheaper, increasing import volume → increasing deficit further.
- Can lead to downward pressure on currency and capital outflows.
- BoP Deficits May Cause Inflation:
- A falling currency can increase import prices → cost-push inflation.
10.2.3 Relationship Between Growth and Inflation
- Demand-Pull Inflation:
- During periods of rapid economic growth, increased demand can exceed supply capacity → pushes prices up.
- Cost-Push Inflation:
- Growth can increase wages and input prices, leading to rising production costs and prices.
- Trade-Off:
- Moderate growth may increase inflation, but excessive inflation can harm growth by reducing purchasing power and increasing uncertainty.
10.2.4 Relationship Between Growth and the Balance of Payments
- Growth and Imports:
- Rising income from growth increases demand for imports → may worsen current account.
- Growth and Exports:
- If growth is export-led, BoP improves due to increased foreign demand.
- Sustainability Concern:
- Growth accompanied by persistent BoP deficits can lead to currency depreciation and external debt.
10.2.5 Relationship Between Inflation and Unemployment: Phillips Curve
Traditional Phillips Curve
- Shows inverse relationship between unemployment and inflation in the short run.
- Lower unemployment → higher inflation due to wage pressures.
Expectations-Augmented Phillips Curve
- Incorporates inflation expectations of workers and firms.
- Short-Run Phillips Curve:
- Shifts based on expected inflation.
- If inflation expectations rise, the curve shifts upward; higher inflation is needed to reduce unemployment.
- Long-Run Phillips Curve:
- Vertical at the natural rate of unemployment (no trade-off between inflation and unemployment in the long run).
- Attempts to keep unemployment below natural rate cause accelerating inflation.
Diagrams
Diagram 1: Internal and External Value of Money
Price Level ↑ (Internal Value ↓)
|
| Depreciation of Currency
| ↓
|______________________________ Exchange Rate ↓ (External Value)
Diagram 2: Inflation and Balance of Payments
Price Level (Inflation) ↑
↓
Export Competitiveness ↓
↓
Balance of Payments Deficit ↑
Diagram 3: Growth and Inflation (Demand-Pull Inflation)
Price Level
↑
| /
| /
| / Aggregate Demand
| /
| /
|_____/___________________→ Output (GDP)
Diagram 4: Growth and Balance of Payments
Income ↑
↓
Import Demand ↑
↓
Current Account Deficit ↑
Diagram 5: Phillips Curve
Inflation Rate
↑
|
|
| SRPC1
| SRPC2 (Higher Expected Inflation)
|
| ________________ LRPC (Natural Rate Unemployment)
|
|______________________________→ Unemployment Rate
Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Economics Full Scale Course