Question

Explain how large-scale structural change might influence the short-run and long-run Phillips curves. Will the influence come from changes in the expected inflation rate, the natural unemployment rate, or both?

Short answer

Large-scale structural changes can influence both expected inflation and the natural unemployment rate, altering both short-run and long-run Phillips Curves.

Step-by-step solution

Understand the Phillips Curve

The Phillips Curve illustrates the inverse relationship between inflation and unemployment. In the short run, it shows that with lower unemployment comes higher inflation, and vice versa.

Identify Short-Run Factors

In the short run, changes in expected inflation can shift the Phillips Curve. If people expect higher inflation, they will act in ways that make higher inflation more likely.

Identify Long-Run Factors

In the long run, the natural unemployment rate (the level of unemployment at which inflation does not increase) plays a crucial role. Structural changes, such as technological advancements or shifts in labor market policies, can alter this natural rate.

Analyze Structural Changes

Large-scale structural changes can affect both expected inflation and the natural unemployment rate. For example, if a new technology increases productivity, it could lower the natural rate of unemployment.

Impact on Short-Run Phillips Curve

Structural changes that alter expected inflation or the natural unemployment rate will shift the short-run Phillips Curve. For instance, an increase in expected inflation will shift the short-run Phillips Curve upward.

Impact on Long-Run Phillips Curve

The long-run Phillips Curve is typically vertical at the natural rate of unemployment. Structural changes can shift this vertical line left or right, depending on whether the natural unemployment rate decreases or increases.

Key concepts

short-run Phillips curve

The short-run Phillips Curve (SRPC) describes an inverse relationship between unemployment and inflation. This means that when unemployment is low, inflation tends to be higher, and when unemployment is high, inflation is usually lower. This concept is closely tied to expectations of inflation.
If people expect inflation to rise, they will adjust their behavior accordingly. For example, workers might demand higher wages to keep up with expected price increases. In response, companies might raise prices, thereby contributing to higher inflation. These changes will shift the SRPC.

• If expected inflation increases, the SRPC shifts upward.
• If expected inflation decreases, the SRPC shifts downward.

It's important to understand that the SRPC is not fixed and can move based on people's inflation expectations and other short-term factors such as government policies and economic shocks.

long-run Phillips curve

Contrary to its short-run counterpart, the Long-Run Phillips Curve (LRPC) is typically represented as a vertical line. This vertical line occurs at the natural rate of unemployment. The LRPC indicates that, in the long-term, there is no trade-off between inflation and unemployment.
This means that regardless of the inflation rate, the economy will settle at its natural unemployment rate.

• If inflation is high or low, unemployment will return to its natural rate.
• Inflation expectations are fully adjusted, meaning they have no effect on the long-term unemployment rate.

However, structural changes in an economy can shift the LRPC. If structural changes reduce the natural unemployment rate, the LRPC shifts to the left. If the natural unemployment rate increases, the curve shifts to the right.

natural unemployment rate

The natural unemployment rate is the rate of unemployment that an economy naturally gravitates towards in the long run, excluding short-term cyclical fluctuations. It includes structural and frictional unemployment but not cyclical unemployment. Factors affecting the natural unemployment rate include:

• Labor market policies
• Technology and productivity changes
• Education and training programs

For example, technological advancements that create more jobs and improve productivity can reduce the natural unemployment rate. On the other hand, obsolete skills or inefficient job markets can increase it.
The natural unemployment rate is crucial for understanding both the short-run and long-run Phillips Curves because it serves as a benchmark. In the long-run, the economy aims to adjust to this natural rate.

expected inflation

Expected inflation is the rate at which people anticipate prices will increase in the future. It plays a significant role in shaping both the short-run and long-run dynamics of the Phillips Curve. In the short-run, changes in expected inflation can shift the SRPC.

• Higher expected inflation generally leads to higher actual inflation.
• Lower expected inflation usually results in lower actual inflation.

In the long run, once expectations adapt fully, expected inflation aligns more closely with actual inflation, and the economy settles at the natural unemployment rate.
When people expect inflation to rise, they make adjustments, such as demanding higher wages or increasing prices, which actually push inflation higher. This interconnectedness highlights why managing inflation expectations is critical for economic stability.

structural changes

Structural changes refer to significant shifts in an economy's framework. These can include technological advancements, changes in labor force composition, or new government policies. Structural changes have a profound impact on both the short-run and long-run Phillips Curves.
For the SRPC, structural changes can alter inflation expectations or the natural rate of unemployment, thereby shifting the curve.

• An increase in expected inflation due to a structural change will move the SRPC upward.
• A decrease in expected inflation will shift it downward.

In terms of the LRPC, structural changes can modify the natural unemployment rate, changing the position of the curve.
For instance, a new technology that enhances productivity could lower the natural unemployment rate, shifting the LRPC left. Alternatively, a structural change that makes certain skills obsolete could increase the natural unemployment rate, shifting the LRPC to the right.