Question

Distinguish between the short-run and the long-run in a macroeconomic analysis. Why is the relationship between unemployment and inflation different in the short-run and the long-run?

Answer 1

In economics, it's extremely important to understand the distinction between the short run and the long run. As it turns out, the definition of these terms depends on whether they are being used in a microeconomic or macroeconomic context. There are even different ways of thinking about the microeconomic distinction between the short run and the long run.

The long run is defined as the time horizon needed for a producer to have flexibility over all relevant production decisions. Most businesses make decisions not only about how many workers to employ at any given point in time (i.e. the amount of labor) but also about what scale of operation (i.e. the size of factory, office, etc.) to put together and what production processes to use. Therefore, the long run is defined as the time horizon necessary not only to change the number of workers but also to scale the size of the factory up or down and alter production processes as desired.

In contrast, economists often define the short run as the time horizon over which the scale of operation is fixed and the only available business decision is the number of workers to employ. (Technically, the short run could also represent a situation where the amount of labor is fixed and the amount of capital is variable, but this is fairly uncommon.) The logic is that even taking various labor laws as a given, it's usually easier to hire and fire workers than it is to significantly change a major production process or move to a new factory or office.

The Phillips curve shows the relationship between inflation and unemployment. In the short-run, inflation and unemployment are inversely related; as one quantity increases, the other decreases. In the long-run, there is no trade-off. In the 1960's, economists believed that the short-run Phillips curve was stable.

Long run:- The non-accelerating inflation rate of unemployment (NAIRU) and Phillips Curve: Although the economy starts with an initially low level of inflation at point A, attempts to decrease the unemployment rate are futile and only increase inflation to point C. The unemployment rate cannot fall below the natural rate of unemployment, or NAIRU, without increasing inflation in the long run.

Short Run:- Theoretical Phillips Curve: The Phillips curve shows the inverse trade-off between inflation and unemployment. As one increases, the other must decrease. In this image, an economy can either experience 2% unemployment at the cost of 4% of inflation, or increase unemployment to 3% to bring down the inflation levels to 2%