10.2 Links Between Macroeconomic Problems and Their Interrelatedness

2026 📋 Syllabus Objectives

By the end of these notes, you should be able to explain:

  1. The relationship between the internal value of money and the external value of money
  2. The relationship between the balance of payments and inflation
  3. The relationship between growth and inflation
  4. The relationship between growth and the balance of payments
  5. The relationship between inflation and unemployment, including:
    • The traditional Phillips curve
    • The expectations-augmented Phillips curve (short-run and long-run)

📖 Main Content

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🔑 Understanding the Big Picture First

Before diving in, it helps to understand what we mean by "macroeconomic problems." These are economy-wide issues that governments try to manage:

  • Inflation — when prices across the economy are rising over time
  • Unemployment — when people who want jobs cannot find them
  • Economic growth — when the total output (goods and services produced) of a country is increasing
  • Balance of payments — a record of all money flowing into and out of a country

The key insight of this subtopic is this: these problems do not exist in isolation. When one changes, it often causes changes in others. Understanding these links helps governments make better decisions.

1. 🏦 The Internal Value of Money vs. The External Value of Money

What is the Internal Value of Money?

The internal value of money refers to what your money can actually buy inside your own country — in other words, its purchasing power at home.

  • If prices are low, your money buys a lot → the internal value is high
  • If prices are high (inflation), your money buys less → the internal value is low

Think of it this way: if a loaf of bread costs 1 dollar today but costs 2 dollars next year, your 1 dollar is worth less than it used to be. Inflation erodes (reduces) the internal value of money.

What is the External Value of Money?

The external value of money refers to how much your currency is worth compared to other countries' currencies — this is the exchange rate.

  • If 1 British pound buys 1.25 US dollars, that is the external value of the pound.
  • If the pound falls so that it only buys 1.10 US dollars, the external value of the pound has decreased (the pound has depreciated).

The Link Between Internal and External Value

These two are closely connected through inflation:

  • When a country has high inflation, its goods become more expensive compared to goods in other countries.
  • Foreign buyers find that country's goods too expensive → demand for that country's currency falls.
  • When demand for the currency falls, the currency depreciates (loses value on the foreign exchange market).
  • So: high inflation (falling internal value) → falling external value of money.

The reverse also holds: if inflation is low and prices are stable (high internal value), the currency tends to be more attractive to foreign buyers, supporting a stronger external value.

In short: A rise in domestic prices (falling internal value) tends to cause a fall in the exchange rate (falling external value), and vice versa.

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