Cambridge International as and a level Economics Ebook

The relationship between the 
balance of payments and inflation
As mentioned above, if a country’s infl ation rate rises above 
that of its main competitors, its price competitiveness will 
0
Price of currency 
Quantity of currency
Q
D
S
1
S
S
D
1
P
P
1
D
1
D
S
1
Figure 10.1 
The eff ect of higher inflation on the external 
value of a currency
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Cambridge International A Level Economics

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fall. Export revenue will decline while import expenditure 
rises and the current account balance will deteriorate.
An increase in a current account surplus may cause 
infl ation as it will mean that net exports are making an 
increasing contribution to aggregate demand and more 
money will be fl owing into the country than leaving it. 
Th
is upward pressure on the domestic price level and so 
downward pressure on the internal value of the currency 
may, however, be short-lived. Th
is is because an increasing 
current account surplus may cause a rise in the exchange 
rate. An appreciation may reduce the surplus and will 
tend to reduce the infl ation rate as the price of imported 
products will fall and there will be more pressure on 
domestic fi rms to keep their prices low.
A net infl ow on the fi nancial account may reduce a 
country’s infl ation rate if MNCs bring in advanced technology 
and increase competitive pressure within the economy.
The relationship between 
unemployment and inflation
Economists have devoted considerable attention to the 
relationship between unemployment and infl ation. Th
e 
most famous study on the relationship was published in 
1958 by Bill Phillips, a New Zealand economist based at 
the London School of Economics. He analysed historical 
data on the relationship between changes in unemployment 
and money wages (taken as an indicator of infl ation) in 
the UK over the period 1861–1957. He found an inverse 
relationship, as shown in 
Figure 10.2
.
A fall in unemployment may cause higher infl ation 
due to extra aggregate demand and the possible upward 
pressure on wages.
Th
e traditional 
Phillips curve
suggests that a government 
can select its best combination of unemployment and 
infl ation and can trade off the two. For example, if the 
current unemployment rate is 8% and its infl ation rate is 
4%, a government may seek to lower unemployment to 5% 
by implementing expansionary fi scal or monetary policy 
measures, while accepting this improvement may have to be 
bought at the cost of higher infl ation.