Long-Run Phillips Curve, Natural Rate and Inflation Effects

Long-Run Phillips Curve (LRPC)

In the long run, economists argue that there is no trade-off between inflation and unemployment. This view is largely influenced by the work of Milton Friedman and Edmund Phelps, who introduced the concept of the Natural Rate of Unemployment (NRU) or the Non-Accelerating Inflation Rate of Unemployment (NAIRU).

Long-Run Mechanisms

1. Natural Rate of Unemployment: The long-run unemployment rate is determined by factors such as labor market policies, minimum wages, and labor productivity. In the long run, unemployment tends to return to this natural rate, regardless of the rate of inflation.
2. Monetary Policy and Expectations: In the long run, if a government tries to reduce unemployment below the natural rate by increasing inflation (via expansionary monetary policy), workers and firms will adjust their expectations. This results in wages rising to match inflation, bringing unemployment back to the natural rate but now at a higher inflation rate. This adjustment negates any long-term gains in employment, leaving unemployment unchanged but inflation persistently higher.
3. Vertical LRPC: Since unemployment eventually returns to the natural rate, the long-run Phillips curve is represented by a vertical line at the NRU, indicating no trade-off between inflation and unemployment. The economy can have high or low inflation without affecting the long-run unemployment rate.

Diagram Explanation

1. The short-run Phillips curve (SRPC) slopes downward, showing an inverse relationship between inflation and unemployment.
2. The long-run Phillips curve (LRPC) is a vertical line at the natural rate of unemployment, suggesting that any attempt to reduce unemployment below this rate will lead to accelerating inflation.
3. When the government increases inflation to reduce unemployment (moving along the SRPC), inflation expectations adjust, shifting the SRPC to the right. This process repeats until the economy stabilizes at the NRU, but with higher inflation.

Factors Leading to a Vertical LRPC

• Adaptive Expectations: Workers eventually anticipate higher inflation, pushing wages up.
• Monetary Neutrality: In the long run, changes in the money supply affect price levels but not real variables like unemployment.