Question

Which of the following statements is correct? (a) The long-run Phillips curve should really have a positive slope because higher inflation makes firms substitute away from workers who are causing the underlying problem. (b) If inflation leads people to economize on some forms of money, this must makethe economy less productive and probably raises long-run unemployment. (c) When other thingsare assumed to be equal, it is a tolerable approximation to view the long-run Phillips curve asvertical.

Short answer

Statement (c) is correct as it aligns with the theory that the long-run Phillips curve is vertical.

Step-by-step solution

Understanding the Long-Run Phillips Curve

The Phillips curve depicts the inverse relationship between inflation and unemployment. However, the long-run Phillips curve is different from the short-run Phillips curve as it reflects the natural rate of unemployment. The long-run Phillips curve is vertical, meaning there is no trade-off between inflation and unemployment in the long run.

Evaluating Statement (a)

Statement (a) suggests the long-run Phillips curve has a positive slope. This is incorrect because the long-run Phillips curve is vertical. A vertical curve indicates that inflation does not affect unemployment rates in the long run.

Evaluating Statement (b)

Statement (b) claims that inflation reducing money use makes the economy less productive, increasing unemployment. While inflation can reduce the need or desire to hold certain types of money, this doesn't inherently reduce productivity or increase long-term unemployment. The main effect of inflation is on money holding behavior, not directly on productivity or long-run unemployment.

Evaluating Statement (c)

Statement (c) correctly states that the long-run Phillips curve can be viewed as vertical, given certain assumptions. This view aligns with economic theory that inflation does not influence long-run unemployment, which remains at the natural rate.

Key concepts

Inflation and Unemployment

The relationship between inflation and unemployment is primarily captured by the Phillips Curve. In the short run, there seems to be an inverse relationship: when inflation is high, unemployment tends to be low, and vice versa. This immediate relationship is due to firms experiencing increased demand and thus hiring more, driving down unemployment. However, this relationship changes in the long run.
In the concept of the Long-run Phillips Curve, the curve is vertical. This indicates that in the long run, there is no relationship between inflation and unemployment. As the economy adjusts to inflationary pressures, employment levels revert to the natural rate of unemployment, irrespective of the inflation rate. Thus, employment is determined not by inflation but by structural factors in the economy.

Natural Rate of Unemployment

The natural rate of unemployment refers to the level of unemployment that the economy normally experiences as it moves to full efficiency. This is the point at which the Long-run Phillips Curve is vertical.

• It includes frictional unemployment—temporary unemployment as workers move between jobs.
• Also includes structural unemployment—unemployment resulting from industrial reorganization or technological change that makes certain skills obsolete.

Therefore, the natural rate is not zero because some levels of unemployment are unavoidable and natural in a healthy economy. It's the rate that persists when the economy is stable, not influenced by short-term cyclical factors.

Economic Theory Assumptions

Economic theories make assumptions to simplify complex real-world phenomena so that relationships, like that in the Phillips Curve, can be understood. For example, the assumption that other things remain equal is crucial for analyzing the Phillips Curve.
This ceteris paribus assumption isolates the effect of inflation and unemployment from other factors that could also influence these variables.
In the long run, the assumption that excess demand, changes in technology, and employment practices remain constant allows economists to conclude that the natural rate of unemployment is not affected by inflation changes. Simplifying assumptions help in deriving clear, generalized predictions from models.