Question

What is the shape of the neoclassical long-run Phillips curve? What assumptions do economists make that lead to this shape?

Short answer

The neoclassical long-run Phillips curve is a vertical line at the natural rate of unemployment, \(U_n\), implying that in the long run, there is no trade-off between inflation and unemployment. The shape is determined by economists' assumptions, such as rational expectations, wage and price flexibility, the existence of a natural rate of unemployment, and monetary policy neutrality. These assumptions lead to the conclusion that inflation and unemployment are independent of each other in the long run.

Step-by-step solution

Understand the Phillips curve

The Phillips curve represents the relationship between inflation and unemployment. In general, the curve shows that when inflation is high, unemployment is low, and vice versa. There are two types of Phillips curve - the short-run and long-run curves.

Explain the neoclassical long-run Phillips curve

The neoclassical long-run Phillips curve is a vertical line at the natural rate of unemployment, denoted as \(U_n\). This implies that in the long run, there is no trade-off between inflation and unemployment - any change in inflation has no effect on the natural rate of unemployment.

Discuss the assumptions leading to this shape

The shape of the neoclassical long-run Phillips curve is determined by several assumptions made by economists: 1. Rational expectations: People form their expectations about future inflation based on all available information, including past inflation, government policies, and economic conditions. 2. Wage and price flexibility: In the long run, wages and prices are fully flexible, meaning they adjust to changes in the economy so that the labor market clears (supply of labor equals demand for labor). 3. Natural rate of unemployment: There exists a level of unemployment, the natural rate, at which the labor market is in equilibrium. This rate is determined by structural factors such as labor market regulations, job training and education programs, and demographics. 4. Monetary policy neutrality: In the long run, changes in monetary policy only affect nominal variables like inflation, but not real variables like unemployment. These assumptions, when combined, lead to the conclusion that the long-run Phillips curve is vertical at the natural rate of unemployment since inflation and unemployment are independent of each other in the long run.