Question

Contrast the natural rate of unemployment supply curve with the Keynesian Phillips Curve.  

(at least 100 words)

Answer 1

Phillip's curve asserts and shows the trade-off between unemployment and inflation. It asserts that as inflation would increase, the unemployment would decrease, since increase in prices usually increase the wages and hence increase unemployment. This led to implement in policies in 1960's. The short run Phillip's curve gives the aggregate supply a positive slope.

However, in the late 60's, Friedman showed that this is true indeed, but only in the short run. In the long run, the unemployment rate would be unchanged while the inflation would stay at the increased level. He asserted that yet the unemployment would increase in the short run, but in the long run, people adjust their expectation, and that would again increase the unemployment to the natural rate of unemployment. This gives the long run aggregate supply a vertical slope.

In the above graph, the vertical axis is the inflation while the horizontal axis is unemployment rate. Suppose the economy is at point A. If the government increases inflation by monetary policy, the inflation would increase, and as a result, the economy would move from A to B along the short run Phillip's curve SRPC1, but as expectations adjust, the economy would return to the natural rate of unemployment , and shift from B to C. If government further increases inflation, economy would again move from C to D in the short run, but would return to natural rate in the long run, and would move D to E. Again, if the inflation is increased, the path would be analogous, and economy would move E to F in the short run along SRPC3, and would again shift from F to G in the long run. Notice that, point A, C, E and G have same level of unemployment, the natural level, but as we go from A to C to E to G, the inflation increases despite the unemployment level remaining same in the long run. The Keynesian Phillip's curve is only the short run Phillip's curve, while Friedman showed the long run Phillip's curve, emphasizing on the natural rate of unemployment.

In aggregate scenario, this is the basis of the long run aggregate supply (LRAS) curve. If the economy moves from point A to B, the production increases as unemployment decreases, and this is the reason the short run (Keyenesian) aggregate supply curve is positively sloped. As the price increases, unemployment decreases and production increases. But, in the long run, the unemployment returns to natural rate, and economy returns to the potential output. The LRAS and SRAS curve corresponding to the above discussion are as below.

As can be seen, the economy moves from A to B, which increases the price, reduce the unemployment and increase the output. As economy adjust to prices, the economy goes from B to C. In C, the output and unemployment is same as A, but the price is more. The same happens to C to D to E. In a more real scenario, where the dynamic aggregate demand and supply works, which changes the output and price more frequently, but the pattern remains the same.