According to Phillips curve unemployment will return to the natural rate when:
- Nominal wages are equal to expected wages
- Real wages are back at equilibrium level
- Nominal wages are growing faster than inflation
- Inflation is higher than the growth of nominal wages
Correct Answer: Real wages are back at equilibrium level
Answer Explanation
According to Phillips curve unemployment will return to the natural rate when real wages are back at equilibrium level. The Phillips curve, a fundamental concept in macroeconomics, reveals the intricate relationship between unemployment and inflation. In option (b), “Real wages are back at equilibrium level,” the key factor that contributes to the restoration of unemployment to its natural level is clearly stated. Let’s examine the Phillips curve and its implications for labor market dynamics:
The Phillips Curve and Equilibrium:
The Phillips curve is characterized by the inverse correlation between unemployment and inflation. Inflation tends to increase as unemployment decreases, and conversely, higher unemployment levels tend to coincide with lower inflation.
However, this relationship is not static. In time, unemployment should return to its natural rate, the non-accelerating inflation rate of unemployment (NAIRU), which is a level consistent with stable inflation. The pathway to this restoration is closely linked to real wage changes.
Consequently, wages tend to rise as workers demand higher compensation in a tighter job market because labor markets tighten when unemployment is below its natural level. Inflationary pressures could result if nominal wages are pressured upward, leading to higher production costs for businesses.
However, as wages increase, the real wage the wage adjusted for inflation may not increase in the same proportion. In fact, if inflation outpaces nominal wage growth, the real wage might even decrease. This adjustment in real wages leads to a return to equilibrium in the labor market and lowers unemployment.
Why the other options are not correct
a. Nominal wages are equal to expected wages:
The alignment of nominal wages with expected wages can indeed impact labor market dynamics, but it does not directly explain how unemployment returns to its natural rate. In the Phillips curve, real wages serve as an important intermediary between unemployment and inflation.
c. Nominal wages are growing faster than inflation:
Real wages and purchasing power are affected by the pace of nominal wage growth relative to inflation. The mechanism by which unemployment returns to a natural rate is not explicitly discussed in this option, however. Although it emphasizes the interplay between wage growth and inflation, it does not directly explain how equilibrium is restored. So, this option is not the correct option.
d. Inflation is higher than the growth of nominal wages:
Although the comparison between inflation and nominal wage growth can affect real wages, this option does not explain how unemployment is returned to its natural level. The paper emphasizes the complex relationship between inflation and wage dynamics without addressing the process of restoring equilibrium directly.
Conclusion
We can comprehend how unemployment and inflation are intertwined through the Phillips curve. Although it suggests that a decrease in unemployment could result in a rise in inflation, it also emphasizes that unemployment has a natural tendency to return to its natural rate when unemployment decreases. Inflation and real wages interact to create this return.
As the labor market adjusts and real wages return to equilibrium levels, unemployment returns to its natural rate. In order to shape effective macroeconomic policies, it is imperative to consider inflation, wages, and unemployment in their multifaceted dynamics.