Macroeconomic objectives

Economic growth is an increase in real GDP over time, where real GDP is the value of final output adjusted for inflation. A production possibilities curve (PPC) shows the maximum combinations of two goods, here capital goods and consumer goods, that an economy can produce when all its resources are fully and efficiently employed, given its technology.

In Diagram 1 the economy starts at point A, inside PPC₁. This means some resources are unemployed, for example workers who lost their jobs in a recession, or are used inefficiently. If these resources are put back to work, or used more efficiently, the economy can produce more of both goods, moving from A towards B on PPC₁. This is growth as an increase in actual output: real GDP rises. However, PPC₁ does not shift, because the quantity and quality of the economy’s resources have not changed. Growth of this kind is limited: it stops once the economy reaches its PPC.

Growth as an increase in production possibilities happens when the quantity or quality of factors of production increases. Examples are investment in new capital goods, a larger labour force through immigration, better education and training that raise workers’ skills, and new technology. In Diagram 2 this shifts the curve outward from PPC₁ to PPC₂, so the economy can now produce combinations such as C, which were unattainable before. Potential output has increased.

The difference is therefore that actual growth means using existing capacity more fully, shown by a movement from inside the PPC towards it, while growth in production possibilities means the capacity itself increases, shown by an outward shift of the PPC. The two can happen separately: if the PPC shifts out but the extra resources remain unemployed, production possibilities grow while actual output does not. Long-term growth requires production possibilities to keep increasing.

Economic growth is an increase in real GDP over time. Short-term growth is an increase in actual output, while long-term growth is an increase in potential output (Y_f): the real GDP the economy produces at full employment, when unemployment is at its natural rate. In the AD/AS model, potential output is shown by the vertical LRAS curve.

Short-term growth is caused mainly by an increase in aggregate demand (AD = C + I + G + (X − M)). For example, higher consumer confidence raises consumption, or lower interest rates encourage investment. In Diagram 1 the economy starts at E₁, below potential output (Y₁ < Y_f), so there is spare capacity. AD shifts from AD₁ to AD₂. Firms respond by hiring unemployed workers and using idle machines, so real GDP rises from Y₁ to Y_f at E₂. LRAS does not move, so potential output is unchanged: the economy is only using its existing capacity more fully.

Long-term growth is caused by increases in the quantity or quality of the factors of production, or by better technology. Examples are investment in physical capital such as machinery and infrastructure, investment in human capital through education and training, and new technology that raises productivity. These increase the economy’s productive capacity, shifting LRAS right from LRAS₁ to LRAS₂ in Diagram 2, so potential output rises from Y_f1 to Y_f2. Lower costs per unit also shift SRAS right. If AD rises by a similar amount, the new long-run equilibrium E₂ has higher real GDP at the same price level, PL₁.

The difference is that short-term growth comes from the demand side and only uses existing capacity, so it can continue only until the economy reaches Y_f; beyond that, more AD mainly causes inflation. Long-term growth comes from the supply side and increases capacity itself, so it can be sustained. Investment can contribute to both: it is a component of AD in the short run and it adds to the capital stock in the long run.

Unemployment refers to people of working age who are willing and able to work and are actively looking for a job, but do not have one. The unemployment rate is the number of unemployed as a percentage of the labour force, where the labour force is all people of working age who are either employed or unemployed. Most countries measure it with a labour force survey using the ILO definition: a person is unemployed if they have no work, have actively looked for work in the past four weeks and could start within two weeks.

First, the official rate ignores hidden unemployment. Discouraged workers, who have given up looking for work after long periods of failure, are no longer actively seeking work, so they are classed as economically inactive rather than unemployed. They drop out of both the number of unemployed and the labour force, so the unemployment rate can fall even though nobody has found a job. People moved onto sickness benefits or into training schemes may also not be counted. In South Africa, for example, the expanded unemployment rate, which includes discouraged work-seekers, was about 10 percentage points higher than the official rate in 2026 (43.8% compared with 33.6%). The official rate therefore understates true unemployment.

Second, the rate does not count underemployment. Someone working a few hours a week who wants full-time work, or a graduate working in a job that does not use their skills, is counted as employed. In a downturn, firms often cut hours rather than jobs, so the unemployment rate can stay low while the amount of unused labour rises.

Third, the unemployment rate is a national average. It hides large differences between regions, age groups, ethnic groups and genders: a national rate of 6% may hide youth unemployment of 15%, or much higher rates in a region where a major industry has closed. On the other hand, the official rate may overstate unemployment if people who report being unemployed are actually working in the informal economy.

Overall, because of hidden unemployment, underemployment and averaging, the official unemployment rate is more likely to understate than overstate the true extent of unemployment in an economy.

Unemployment refers to people of working age who are willing and able to work and actively looking for work, but without a job. Cyclical (demand-deficient) unemployment is caused by a fall in aggregate demand, while structural unemployment is caused by a mismatch between the skills or location of workers and the jobs available.

In Diagram 1 the economy starts in long-run equilibrium at E₁, where AD₁, SRAS and LRAS meet at potential output Y_f. If AD falls, for example because consumer and business confidence falls at the start of a recession, AD shifts left from AD₁ to AD₂. Firms sell less, so they cut production: real GDP falls from Y_f to Y₂ at E₂. Because the demand for labour is derived from the demand for goods and services, firms across the economy need fewer workers and lay them off. The recessionary gap (Y_f − Y₂) is lost output, and the workers no longer needed to produce it are cyclically unemployed. This unemployment rises in the downturn of the business cycle and falls again when AD recovers.

Structural unemployment occurs when the structure of the economy changes. Diagram 2 shows the labour market for one type of worker in one region, for example coal miners. If cheaper imported energy or a switch to renewables reduces the demand for coal, the demand for coal miners falls from DL₁ to DL₂. If wages do not fall (they are sticky downwards), firms employ only Q₂ workers at W₁ while Q₁ workers want to work, so Q₁ − Q₂ become unemployed. These workers often cannot simply move into growing industries, because they lack the skills needed (occupational immobility) or the new jobs are in other regions (geographical immobility). Labour market rigidities, such as a minimum wage above the equilibrium wage, can cause structural unemployment in a similar way.

The difference is therefore in the cause and how long it lasts. Cyclical unemployment is caused by too little AD across the whole economy and falls when AD recovers, so it is usually shorter-term. Structural unemployment is caused by changes in demand for particular skills, the relocation of industries and labour market rigidities in particular markets or regions; it is part of the natural rate of unemployment, exists even when the economy is at Y_f, and tends to be long-term because workers need retraining or relocation, not just more spending.

Full employment does not mean zero unemployment. The full employment level of output (Y_f) is the real GDP produced when the economy is in long-run equilibrium on its LRAS curve. At this point there is no cyclical (demand-deficient) unemployment, but unemployment is still equal to the natural rate of unemployment, which is the sum of frictional, seasonal and structural unemployment.

In Diagram 1 the economy is at Y_f, where AD, SRAS and LRAS intersect. There is enough AD, so nobody is unemployed because of a lack of spending. However, some people are always between jobs, for example a graduate searching for a first job or a worker who has quit to find a better one. This frictional unemployment exists because information about jobs and workers is imperfect, so matching takes time. Others are seasonally unemployed because the demand for their labour changes with the seasons, such as hotel workers in a beach resort in winter.

Structural unemployment also exists at Y_f. It comes from changes in demand for particular skills (for example, automation reducing demand for factory workers), from industries moving to other regions, and from labour market rigidities. Diagram 2 shows a minimum wage set above the equilibrium wage (W_min > W_e). At W_min firms want to hire only Q_d workers, while Q_s people want to work. The excess supply of labour, Q_s − Q_d, is unemployment, and because the law stops the wage from falling, it does not disappear. Other rigidities, such as strict firing rules that make firms cautious about hiring, have a similar effect.

So unemployment remains at Y_f because its causes lie in how labour markets work (imperfect information, seasonal swings in labour demand, mismatched skills and location, and rigidities), not in a lack of aggregate demand. Increasing AD beyond Y_f would reduce unemployment below the natural rate only temporarily, and would cause inflation.

Inflation is a sustained increase in the general (average) price level in an economy over time. It is usually measured with a consumer price index (CPI), which tracks the cost of a fixed basket of goods and services bought by a typical household, compared with a base year that is given the value 100.

To construct the CPI, statisticians use a household expenditure survey to find out what typical households buy, and choose a representative basket, for example food, housing, transport and clothing. Each item is weighted by its share of household spending, so a 10% rise in housing costs, which take up a large share of spending, raises the CPI more than a 10% rise in the price of clothing. Prices are collected regularly from many shops and regions, and the weighted average change in prices is turned into an index number. The inflation rate is the percentage change in the CPI: [(CPI this year − CPI last year) ÷ CPI last year] × 100.

The CPI lets us distinguish the three terms, as the diagram shows. If the CPI rises from 100 in Year 1 to 106 in Year 2, the inflation rate is 6.0%: this is inflation. If it then rises from 106 to 109.2, the inflation rate falls to 3.0%. This is disinflation: a fall in the rate of inflation, but the price level is still rising, only more slowly. If the CPI then falls from 109.2 to 108.1, the inflation rate is −1.0%. This is deflation: a fall in the general price level.

The key distinction is therefore between the rate of inflation and the price level itself: during disinflation the price level keeps rising, whereas during deflation it falls, giving a negative inflation rate. Because prices can fall briefly for one-off reasons, economists look for a sustained change before calling it inflation or deflation.

The consumer price index (CPI) measures the average change in the prices of a fixed basket of goods and services bought by a typical household, with each item weighted by its share of household spending. The cost of living is the amount a household must spend to maintain its standard of living. Because the CPI is based on an “average” household and a basket that changes only occasionally, it may not reflect the change in the cost of living for every household.

First, households on different incomes have different consumption patterns. Low-income households spend a larger share of their income on necessities such as food and energy, while high-income households spend more on services such as travel and eating out. When food and energy prices rise faster than other prices, as they did in 2022 after Russia’s invasion of Ukraine, low-income households face a higher personal inflation rate than the CPI shows. In the example in the diagram, the CPI rises by 5.5%, but the low-income household faces 7.0% and the high-income household 4.0%. The CPI understates the rise in the cost of living for poorer households and overstates it for richer ones.

Second, consumption patterns change over time. When the price of a good rises, households switch to cheaper alternatives, for example chicken instead of beef, and new products such as streaming services replace older ones. Because the basket and weights are updated only periodically, the CPI may assume households are still buying the more expensive goods, so it tends to overstate the true increase in the cost of living.

Third, the CPI may not fully account for changes in quality. If a laptop’s price rises by 5% but it is much faster and lasts longer, part of the price increase is payment for better quality rather than inflation. If this is not adjusted for, the CPI overstates inflation; if quality falls while the price stays the same, it understates it.

Therefore, because spending patterns differ between households, baskets and weights change more slowly than consumers do, and quality changes are hard to measure, the CPI is only an approximate measure of changes in the cost of living, and it may overstate or understate them for particular households.

Inflation is a sustained increase in the general price level. Demand-pull inflation is caused by an increase in aggregate demand (AD), while cost-push inflation is caused by an increase in firms’ costs of production, which reduces short-run aggregate supply (SRAS).

In Diagram 1 the economy starts in long-run equilibrium at E₁, producing potential output Y_f at price level PL₁. If a component of AD increases, for example consumption rises because consumer confidence is high, or exports rise because incomes abroad are growing, AD shifts right from AD₁ to AD₂. At PL₁ there is now excess demand. Because the economy is already at potential output, with little spare capacity, firms can only raise output by paying overtime and competing for scarce workers and raw materials, which raises their costs, so they raise prices. The new equilibrium is E₂: the price level rises to PL₂ and real GDP rises to Y₂, above Y_f. This creates an inflationary gap, with unemployment below the natural rate.

In Diagram 2, cost-push inflation starts from higher costs of production, such as a rise in world oil prices, wage increases greater than productivity growth, or a depreciation that makes imported raw materials more expensive. Firms can now supply each level of output only at a higher price, so SRAS shifts left from SRAS₁ to SRAS₂. The new equilibrium is E₂: the price level rises from PL₁ to PL₂, but real GDP falls from Y_f to Y₂. Firms need fewer workers, so unemployment rises. This combination of inflation and falling output is called stagflation. For example, the jump in energy prices after Russia’s invasion of Ukraine in 2022 helped push UK inflation to 11.1%.

Both types raise the price level, but they differ in cause and in their effect on output. Demand-pull inflation starts on the demand side (AD shifts right) and comes with higher real GDP and lower unemployment. Cost-push inflation starts on the supply side (SRAS shifts left) and comes with lower real GDP and higher unemployment.

Deflation is a sustained fall in the general price level, so the inflation rate is negative. It is different from disinflation, where prices are still rising but more slowly. Two important costs of deflation are deferred consumption, which can lead to a deflationary spiral, and an increase in the real value of debt.

First, when consumers see prices falling and expect them to keep falling, they postpone purchases, especially of expensive durable goods such as cars and electronics, because waiting means paying less. This reduces consumption, a major component of AD. In the diagram, AD shifts left from AD₁ to AD₂: firms sell less, so they cut output and prices, and real GDP falls from Y_f to Y₂ while the price level falls from PL₁ to PL₂. Because labour is a derived demand, firms lay off workers, so cyclical unemployment rises. Lower incomes and further expected price falls reduce spending again, shifting AD to AD₃. This self-reinforcing process is a deflationary spiral, and it can turn a mild downturn into a long period of stagnation, as in Japan, where consumer prices were falling or flat in most years between 1999 and 2012.

Second, deflation increases the real value of debt. Loans are fixed in money terms, but when prices and money incomes fall, households and firms must give up more purchasing power to repay the same debt. Borrowers therefore cut spending to repay what they owe, reducing AD further, and some cannot repay at all, so firms and households go bankrupt. Widespread defaults weaken banks and make them less willing to lend, which reduces investment. During the Great Depression, US prices fell by about a quarter between 1929 and 1933, and the rising real burden of debt contributed to waves of bankruptcies and bank failures.

Both costs show why deflation is feared: by reducing spending, it lowers real GDP and raises unemployment, and the effects can feed on themselves.

Deflation is a sustained fall in the general price level, so the inflation rate is negative. It is different from disinflation, where prices are still rising but more slowly. Deflation can be caused by a fall in aggregate demand (AD) or by an increase in short-run aggregate supply (SRAS).

In Diagram 1 the economy starts in long-run equilibrium at E₁, where AD₁, SRAS and LRAS meet at Y_f and price level PL₁. If AD falls, for example because a financial crisis destroys consumer and business confidence so that consumption and investment fall, AD shifts left from AD₁ to AD₂. At PL₁ firms cannot sell all their output, so they cut prices and reduce production. The new equilibrium is E₂: the price level falls to PL₂ and real GDP falls to Y₂. If AD stays weak, the price level keeps falling. This is deflation caused by falling AD, sometimes called “bad” deflation because it comes with falling output and rising cyclical unemployment, as in Japan, where prices were falling or flat in most years between 1999 and 2012.

In Diagram 2, deflation comes from the supply side. If firms’ costs of production fall, for example because world energy prices or the prices of imported raw materials fall, firms can supply each level of output at a lower price, so SRAS shifts right from SRAS₁ to SRAS₂. At PL₁ there is now excess supply, so competition pushes prices down. The new equilibrium is E₂: the price level falls from PL₁ to PL₂ while real GDP rises from Y₁ to Y₂. Higher productivity from new technology has the same effect, and also shifts LRAS right. This is sometimes called “good” deflation, because falling prices come with rising output and real incomes.

So both a fall in AD and a rise in SRAS lower the price level, but with opposite effects on output: deflation caused by falling AD reduces real GDP and raises unemployment, while deflation caused by rising SRAS increases real GDP.

The objective of low unemployment means keeping unemployment close to the natural rate of unemployment (NRU), the unemployment that exists at the full employment level of output (Y_f), when there is no cyclical unemployment. Low and stable inflation means a low, predictable rate of increase in the general price level; many central banks target about 2%. A conflict exists if achieving one objective makes the other harder to achieve.

The diagram uses the Keynesian AS curve. At AD₁ the economy is in a deep recession at Y₁, with high cyclical unemployment. In this flat section (I) there is a lot of spare capacity: firms can hire unemployed workers and use idle machines without their costs rising, so an increase in AD would reduce unemployment without raising the price level. Here there is no conflict.

However, as AD rises to AD₂, the economy enters the upward-sloping section (II). Real GDP rises to Y₂ and unemployment falls, but the price level rises from PL₁ to PL₂. This is because spare capacity is running out: firms face bottlenecks, pay overtime and compete for scarce skilled workers and materials, so their costs rise and they raise prices. If AD rises further to AD₃, the economy reaches full capacity at Y_f (section III), where extra AD cannot raise output any further and only pushes the price level up to PL₃. At Y_f, extra AD cannot cut unemployment any further; it only causes demand-pull inflation.

Therefore there is a conflict between low unemployment and low inflation when the economy is close to full employment: the same increase in AD that reduces cyclical unemployment creates demand-pull inflation. The conflict is weak when there is a lot of spare capacity, and it can be eased if potential output grows (the AS curve shifts right). A cost-push shock can make both objectives worse at once, because rising costs raise prices while reducing output and employment (stagflation).

Unemployment refers to people of working age who are willing and able to work and actively seeking work but without a job. Inflation is a sustained increase in the general price level. Both impose costs on an economy, but the costs differ in size, in who bears them and in how long they last.

The main economic cost of unemployment is lost output. Unemployed workers could be producing goods and services, so the economy produces inside its PPC; in the diagram, the recessionary gap Y_f − Y₂ is output that is lost for ever. The government also loses tax revenue and pays more in unemployment benefits, which increases its budget deficit. If unemployment lasts, workers lose skills and find it harder to get jobs later (hysteresis), which can raise the natural rate of unemployment and reduce potential output. Unemployment also has personal costs, such as loss of income, debt, stress and poorer health, and social costs, such as crime and greater inequality.

The costs of inflation are different. Rising prices reduce the purchasing power of people whose incomes do not keep up, such as pensioners on fixed incomes, and when inflation is higher than expected they redistribute purchasing power from savers and lenders to borrowers. Unpredictable inflation creates uncertainty, so firms delay investment, which slows long-term growth, and if prices rise faster than in other countries, exports become less competitive. Low-income households are hit hardest, because necessities such as food and energy take up a larger share of their spending.

Comparing the two, the costs of unemployment are concentrated on a minority but are very large for them, and lost output can never be recovered. The costs of moderate inflation are spread thinly across everyone and are smaller if wages and interest rates rise with prices. This is why well-being studies find that a one percentage point rise in unemployment lowers well-being more than five times as much as a one percentage point rise in inflation (Blanchflower and co-authors, 2014). However, the relative costs depend on magnitude: very high inflation or hyperinflation, as in Zimbabwe in 2008, damages the whole economy and can be more costly than moderate unemployment.

High economic growth is a rapid increase in real GDP. Low inflation means a low and stable rise in the general price level; environmental sustainability means meeting present needs without reducing the ability of future generations to meet theirs; and equity in income distribution means a fair distribution of income. High growth can conflict with each of these, but the connection depends on how the growth is achieved.

If growth comes mainly from rising AD while the economy is close to full employment, it conflicts with low inflation. In the demand-pull diagram, AD shifts from AD₁ to AD₂: real GDP rises above Y_f to Y₂, but firms face bottlenecks and rising costs, so the price level rises from PL₁ to PL₂. However, if growth comes from increases in productive capacity, such as investment and new technology, LRAS shifts right (Diagram 2), so real GDP can rise from Y_f1 to Y_f2 without the price level rising. There is little conflict when growth is supply-led.

High growth usually means more production, more energy use and more use of natural resources. Firms ignore the external costs of pollution, so in the externality diagram the market produces Q_m, more than the socially optimal Q_opt, because MSC > MPC. Fast growth can therefore deplete resources and raise greenhouse gas emissions; China, for example, became the world’s largest emitter of CO2 during its rapid growth, which conflicts with sustainability. The conflict is weaker if growth is based on renewable energy, energy efficiency and services.

Growth can also increase inequality if most of the extra income goes to owners of capital and highly skilled workers, as in China, where the Gini coefficient rose from about 0.3 in the early 1980s to an official peak of 0.49 in 2008. But growth also creates jobs and raises tax revenue that can pay for education and healthcare, which can reduce poverty, so its effect on equity depends on who benefits from the growth.

Therefore high growth is most likely to conflict with these objectives when it is AD-led near full employment, resource-intensive and unequally shared, and least likely when it is supply-led, green and inclusive.