No Such Thing as a Free Lunch: Principles of Economics (Part 146)

Unemployment diminishes people. Leisure enlarges them.

MASON COOLEY

The Labor Market, Unemployment, and Inflation (Part F)

by

Charles Lamson

The Long-Run Aggregate Supply Curve, Potential GDP, and the Natural Rate of Unemployment

Many economists believe the aggregate supply (AS) curve is vertical in the long run. In the short run, we know that some input prices (which are costs to firms) lag behind increases in the overall price level. If the price level rises without a full adjustment of costs, firms' profits will be higher and output will increase. If input prices rise in subsequent periods, driving up costs, the short run-aggregate supply curve will shift to the left, and aggregate output will fall.

Recall from part 144 that the Phillips Curve is an economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. The theory claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment.

This story is directly related to the Phillips Curve. Those who believe the AS curve is vertical in the long run at potential GDP also believe the Phillips Curve is vertical in the long run at some natural rate of unemployment. Recall from part 105 that the natural rate of unemployment refers to unemployment that occurs as a normal part of the functioning of the economy. It is sometimes taken as the sum of frictional unemployment and structural unemployment. The logic behind the vertical Phillips Curve is that whenever the unemployment rate is pushed below the natural rate, wages begin to rise, thus pushing up costs. This leads to a lower level of output, which pushes the unemployment rate back up to the natural rate. At the natural rate, the economy can be considered to be at full employment.

The Nonaccelerating Inflation Rate of Unemployment (NAIRU)

In Figure 10 the long-run Phillips Curve is a graph with the inflation rate on the vertical axis and the unemployment rate on the horizontal axis. The natural rate of unemployment is U*. In the long run, according to advocates of the long-run vertical Phillips Curve, the actual unemployment rate moves to U* because of the natural workings of the economy.

Macroeconomists are currently debating whether equations estimated under the NAIRU theory are good approximations. More time is needed before any definitive answers can be given. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 569-571*

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