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, representing no trade-off between inflation and unemployment in the long run. This shape is derived from assumptions like rational expectations, wage and price flexibility, and the natural rate of unemployment. In the long run, individuals adjust their inflation expectations, wages and prices are fully flexible, and the economy converges to a natural rate of unemployment determined by structural factors. Hence, inflation and unemployment are unrelated in the long run.

Step-by-step solution

Introduce the Phillips curve

The Phillips curve represents the relationship between the rate of inflation and the rate of unemployment in an economy. The short-run Phillips curve shows a trade-off between inflation and unemployment. In contrast, the neoclassical long-run Phillips curve is derived from different assumptions about how the economy operates in the long run.

Describe the shape of the neoclassical long-run Phillips curve

The shape of the neoclassical long-run Phillips curve is vertical, meaning that it shows no trade-off between inflation and unemployment. In the long run, the rate of unemployment is independent of the rate of inflation. The curve is typically drawn as a vertical line at the level of the natural rate of unemployment, which is the long-run equilibrium unemployment rate in the economy.

Explain the assumptions behind the neoclassical long-run Phillips curve

There are several assumptions that economists make to arrive at the vertical long-run Phillips curve. These include: 1. Rational expectations: This assumption holds that individuals and firms in the economy have rational expectations about the future and make decisions based on this information. In the long run, people adjust their expectations about inflation, and this negates any trade-off between inflation and unemployment. 2. Wage and price flexibility: In the long run, nominal wages and prices are assumed to be fully flexible, allowing the economy to adjust and reach equilibrium. With fully flexible wages and prices, the aggregate supply curve becomes vertical, which implies that in the long run, changes in inflation have no effect on the level of output and, consequently, unemployment. 3. Natural rate of unemployment: The natural rate of unemployment is the level of unemployment that prevails in the long run when the economy is operating at its potential output. This rate is determined by structural factors, such as the labor market institutions, demographics, and individual preferences towards work and leisure. In the long run, the economy tends to converge to this rate, with inflation having no lasting impact on unemployment. These assumptions lead to the vertical shape of the neoclassical long-run Phillips curve, indicating that in the long run, inflation and unemployment are unrelated.

Key concepts

Phillips curve relationship

The Phillips curve depicts a key economic concept illustrating the inverse relationship between inflation and unemployment. This relationship is observed when considering the short-term fluctuations of an economy. Originally, economists believed that lower unemployment could be achieved at the expense of higher inflation, and vice versa. The short-run Phillips curve therefore slopes downwards to the right, indicating that higher rates of inflation correspond with lower unemployment levels.

However, the long-run Phillips curve modifies this view. It suggests that there is no long-term trade-off between inflation and unemployment; instead, the relationship breaks down over the long run due to adjustments in people's expectations. This leads to a vertical long-run Phillips curve at the natural rate of unemployment – the rate where the economy is in a long-term equilibrium with full employment and stable inflation.

Natural rate of unemployment

The natural rate of unemployment is a foundational concept in the study of economics. It represents the level of unemployment consistent with a stable rate of inflation, where the economy is at its full-employment equilibrium. Unlike the frictional or cyclical unemployment that fluctuates with the economic cycle, the natural rate of unemployment is determined by longer-term structural factors within the labor market.

Factors such as labor market policies, technology, education, and the preferences of the labor force influence this natural rate. For example, advances in technology might render certain jobs obsolete, leading to structural unemployment. Over time, the natural rate of unemployment is the level towards which the economy gravitates, irrespective of the ongoing inflation. Understanding this concept is crucial as it highlights that attempts to reduce unemployment below the natural rate through monetary policy can only be temporary and will usually lead to accelerating inflation.

Rational expectations

The theory of rational expectations plays a significant role in the neoclassical interpretation of the Phillips curve. It posits that individuals and firms make forecasts about the future based on all available information, and these expectations are, on average, correct. Rather than being systematically wrong, economic agents learn from past mistakes and adjust their behavior accordingly.

When applied to inflation, this theory suggests that if people expect higher inflation in the future, they will adjust their wage demands promptly to maintain their purchasing power. Consequently, any attempts by policymakers to exploit the short-run trade-off between inflation and unemployment will be neutralized in the long run, as people's expectations adapt. This adaptive behavior results in the long-run Phillips curve being vertical: any increase in inflation will be anticipated, leading to corresponding wage increases, and thus not affecting the unemployment rate.

Wage and price flexibility

Wage and price flexibility is assumed to be absolute in the long-run within a neoclassical economy. This means that wages and prices can adjust smoothly in response to changes in supply and demand conditions. Unlike in the short run, where sticky wages and prices might prevent the economy from reaching equilibrium, the long-run perspective allows for full adjustment.

The implication of this assumption is profound. It ensures that, eventually, the economy self-corrects, with employment returning to its natural rate. In a flexible environment, neither an increase nor a decrease in aggregate demand leads to a sustained change in the real output or unemployment. Instead, changes in the demand side of the economy only result in proportional changes in the price level. This underpins the verticality of the long-run Phillips curve, illustrating the core principle that long-term inflation does not influence the natural rate of unemployment and thus does not affect the real economy.