Long Run Phillips Curve: Videos & Practice Problems

The long-run Phillips curve illustrates the relationship between unemployment and inflation when the economy operates at potential GDP. Unlike the short-run Phillips curve, which shows a trade-off between inflation and unemployment, the long-run Phillips curve is vertical. This vertical line indicates that the unemployment rate stabilizes at the natural rate, approximately 4%, regardless of the inflation rate. This means that in the long run, inflation can vary, but the unemployment rate remains constant at the natural rate. This concept emphasizes that monetary policy cannot permanently reduce unemployment below this natural rate without causing accelerating inflation.

The long-run Phillips curve is vertical because it represents a situation where the economy is at its potential GDP, and the unemployment rate is at its natural rate. At this point, all resources are used efficiently, and any unemployment is due to frictional and structural factors, not cyclical ones. This vertical nature indicates that in the long run, there is no trade-off between inflation and unemployment. Regardless of the inflation rate, the unemployment rate remains fixed at the natural rate. This reflects the idea that attempts to reduce unemployment below the natural rate will only lead to higher inflation without affecting long-term unemployment.

The natural rate of unemployment is the level of unemployment that exists when the economy is at potential GDP. It includes frictional and structural unemployment but excludes cyclical unemployment. Frictional unemployment occurs when people are temporarily between jobs or entering the workforce, while structural unemployment arises from mismatches between workers' skills and job requirements. The natural rate is considered to be around 4% in many economies. At this rate, inflation is stable, meaning it has no tendency to increase or decrease. This concept is crucial for understanding the long-run Phillips curve, which shows that unemployment remains at this natural rate regardless of inflation levels.

The long-run Phillips curve differs from the short-run Phillips curve in its representation of the relationship between unemployment and inflation. The short-run Phillips curve shows a negative relationship, indicating a trade-off between inflation and unemployment. In the short run, lower unemployment can be achieved at the cost of higher inflation and vice versa. However, the long-run Phillips curve is vertical, indicating that in the long run, the unemployment rate is fixed at the natural rate, regardless of the inflation rate. This distinction highlights that while monetary policy can influence unemployment and inflation in the short run, it cannot permanently reduce unemployment below the natural rate without causing accelerating inflation.

The long-run Phillips curve has significant implications for monetary policy. It suggests that in the long run, monetary policy cannot reduce unemployment below the natural rate without causing accelerating inflation. This means that while central banks can influence inflation and unemployment in the short run, their ability to affect long-term unemployment is limited. Policymakers should focus on maintaining stable inflation rather than trying to reduce unemployment below its natural rate. Attempts to do so will only lead to higher inflation without achieving a permanent reduction in unemployment. This understanding helps guide central banks in setting appropriate monetary policies to ensure long-term economic stability.