Question

One critique of the basic Phillips curve is that it ignores:

A. the role of real interest rates

B. the role of nominal interest rates

C. the contribution of structural unemployment

D. the role of inflation expectations

Answer 1

The correct option is (D)

Basic Phillips curve shows the inverse relationship between Inflation and unemployment. Actually this hold true in short run only. But in long run, it does not show a negative relationship. expected rate of inflation depends highly on past rate of inflation. When an economy is going through a phase of continuous inflation, expected inflation rate will keep on changing as in every period, people observes a higher rate of past years inflation. expected inflation rate increases shifting the Phillips curve upward. Thus, in long run, actual inflation becomes higher and higher even if unemployment stays at the same level. This gives a vertical Long Run Phillips Curve which is a sharp contrast to a downward sloping basic Phillips curve.

This gives the concept of NAIRU, the rate of unemployment, also referred to as long run Phillips curve, is the non accelarating inflation rate of unemployment. At this level of unemployment, inflation does not further rise.