Question

According to Friedman, how do we know when the economy is in long-run equilibrium?

Short answer

According to Friedman, we know when the economy is in long-run equilibrium when the unemployment rate aligns with the natural rate of unemployment, inflation expectations are stable, and the real GDP is at its full-employment level. Here, any changes in monetary policy cannot permanently affect the real variables in the economy.

Step-by-step solution

Understanding Long-Run Equilibrium

The term long-run equilibrium in economics typically refers to a state where economic factors such as supply and demand are balanced, and in the case of Friedman, it also suggests a state where the rate of unemployment has settled at the natural rate – a condition known as 'monetary neutrality.'

Friedman's View on Long-run Equilibrium

Friedman's theory argues that in the long-run equilibrium, no monetary policy can change the natural rate of unemployment. The economy automatically adjusts itself to achieve this equilibrium. Therefore, any change in monetary policy will only have temporary effects on the economy's real variables. After the short-terms effects wear off, the economy returns to the natural rate of unemployment, indicating a long-run equilibrium.

Identifying Long-Run Equilibrium

According to Friedman, we know when the economy is in long-run equilibrium when the unemployment rate is at its natural level, inflation expectations are stable, and real GDP is at its full-employment level. In this state, any attempts to alter the real variables of the economy with monetary policies will be fruitless as the economy is self-adjusting.