Chapter 26: The Neoclassical Perspective
While Keynesian economics excels at explaining short-run recessions, the neoclassical perspective takes the long view. Neoclassical economists argue that over time, flexible wages and prices guide the economy back toward its potential GDP, making aggregate supply — not aggregate demand — the ultimate determinant of output. This chapter explores the neoclassical building blocks, their policy implications, and how to balance both perspectives.
Table of Contents
1. The Building Blocks of Neoclassical Analysis
Building Block 1: Potential GDP Determines the Economy’s Size
Neoclassical Perspective: In the long run, the economy will fluctuate around its potential GDP and its natural rate of unemployment. Short-run fluctuations are temporary; the long-run trend is what matters.
Potential GDP depends on three factors:
| Factor | How It Drives Growth |
|---|---|
| Physical capital per person | More and better machinery, equipment, and technology available to each worker |
| Human capital | Higher education, skill levels, and training — U.S. college completion rose from ~2.5% (1900) to 33% (2019) |
| Technological advances | GPS, barcodes, computers, biotechnology — each innovation increases output per worker |
U.S. Historical Evidence:
- Population tripled in the 20th century (76 million → 300+ million)
- High school completion went from 12.5% to 85%+
- Technology transformed every sector
- Result: Potential GDP has grown enormously since 1900
Actual GDP vs. Potential GDP (U.S., 1958–2020):
- Most recessions and expansions represent only 1–3% deviations from potential GDP
- After the Great Recession (2008–09), the economy fell below potential and didn’t return until 2018
- The pandemic pushed GDP below potential again in 2020
- Despite short-run fluctuations, the upward trend of potential GDP determines the economy’s long-run size
In the AD/AS model, neoclassical economists draw the LRAS curve as a vertical line at potential GDP. This means:
- The level of aggregate supply (potential GDP) determines real output
- Aggregate demand cannot change long-run output — it only affects the price level
- Over time, LRAS shifts right as productivity grows
Building Block 2: Flexible Prices Restore Equilibrium
The neoclassical self-correction mechanism is the most important concept in this chapter. The following diagram shows how the economy returns to potential GDP after a positive AD shock:
When AD increases (economy goes above potential GDP):
| Step | What Happens |
|---|---|
| 1. Short run | AD shifts right → output rises above potential GDP, prices rise (E₀ → E₁) |
| 2. Labor market | Unemployment falls below natural rate → labor shortage → employers bid up wages |
| 3. SRAS shifts | Rising wages increase production costs → SRAS shifts left (SRAS₀ → SRAS₁) |
| 4. Long run | Economy returns to potential GDP at a higher price level (E₂) |
Numerical Example:
- Original equilibrium: Output = 500, Price level = 120 (at potential GDP)
- AD increases → Short-run: Output = 550, Price level = 125
- Wages rise → SRAS shifts left → Long-run: Output = 500 again, Price level = 130
The surge in AD ended up as inflation, not permanent output growth.
When AD decreases (economy falls below potential GDP):
| Step | What Happens |
|---|---|
| 1. Short run | AD shifts left → output falls below potential GDP, prices fall (E₀ → E₁) |
| 2. Labor market | Unemployment rises above natural rate → surplus of workers → wages stagnate or fall |
| 3. SRAS shifts | Lower wages decrease production costs → SRAS shifts right (SRAS₀ → SRAS₁) |
| 4. Long run | Economy returns to potential GDP at a lower price level (E₂) |
Key Neoclassical Takeaway: Whether AD increases or decreases, the economy self-corrects back to potential GDP in the long run. Changes in AD only have a permanent effect on the price level, not on output or employment.
How Fast Is the Adjustment?
This is the most contentious question in macroeconomics.
Rational Expectations: People form the most accurate possible expectations about the future, using all available information. If people and firms have rational expectations, adjustment happens very quickly — they anticipate the long-run outcome and adjust prices/wages immediately rather than going through a slow process.
Example: If a surge in government spending occurs, rational agents know it will ultimately only raise the price level (since LRAS is vertical). So they raise prices immediately, skipping the drawn-out adjustment process.
Adaptive Expectations: People look at past experience and gradually adapt their beliefs and behavior as circumstances change. They aren’t perfect information processors — adjustment happens incrementally over time.
| Theory | Speed of Adjustment | Implication |
|---|---|---|
| Rational expectations | Very fast (weeks to months) | Policy is largely ineffective — people anticipate and offset it |
| Adaptive expectations | Slow (years) | Policy can have short-run effects, but still wears off eventually |
| Empirical evidence | 2–5 years (reasonable guess) | Short-run Keynesian effects last 2–5 years; after that, neoclassical forces dominate |
Keynes’ famous retort: “In the long run we are all dead.” If adjustment takes many years, the neoclassical perspective may be theoretically correct but practically unhelpful for people suffering through a recession right now.
2. Policy Implications of the Neoclassical Perspective
The Neoclassical Case Against Active Fiscal Policy
Neoclassical economists are skeptical of Keynesian “fine-tuning” for several reasons:
| Problem | Explanation |
|---|---|
| Recognition lag | It takes months just to get preliminary GDP estimates — policymakers may not know a recession is happening |
| Decision lag | The political process takes additional months to enact tax cuts or spending changes |
| Implementation lag | Once enacted, it takes still more months for spending to flow through the economy |
| Self-correction | The average post-WWII U.S. recession lasted only about a year — by the time fiscal policy takes effect, the recession may already be over |
| Pro-cyclical risk | Stimulus may arrive when the economy is already recovering, overheating it instead of stabilizing it |
The neoclassical critique: Active macroeconomic policy is likely to exacerbate business cycles rather than dampen them. Some neoclassical economists believe a large part of observed business cycles are actually caused by flawed government policy.
The Neoclassical Phillips Curve
In the Keynesian view, the Phillips curve slopes downward — there’s a trade-off between unemployment and inflation. In the neoclassical view:
The Long-Run Phillips Curve is Vertical at the natural rate of unemployment.
- With a vertical LRAS curve, shifts in AD change the price level but not output or employment
- Therefore, the economy can have any inflation rate while unemployment stays at the natural rate
- There is no permanent trade-off between inflation and unemployment
As Milton Friedman (Nobel Prize, 1976) said: “There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off.”
Expectations-Augmented Phillips Curve
The formal relationship between inflation, expectations, and unemployment is captured by the expectations-augmented Phillips curve:
\[\pi = \pi^e - \beta(u - u^*)\]Where:
- $\pi$ = actual inflation rate
- $\pi^e$ = expected inflation rate
- $\beta$ = sensitivity of inflation to the unemployment gap (positive constant)
- $u$ = actual unemployment rate
- $u^*$ = natural rate of unemployment (NAIRU)
Worked Example — Expectations-Augmented Phillips Curve:
Suppose $\pi^e = 3\%$, $\beta = 0.5$, $u^* = 5\%$.
| Scenario | $u$ | Calculation | $\pi$ |
|---|---|---|---|
| Boom | 3% | $3\% - 0.5(3\% - 5\%) = 3\% + 1\%$ | 4% |
| At potential | 5% | $3\% - 0.5(5\% - 5\%) = 3\%$ | 3% |
| Recession | 8% | $3\% - 0.5(8\% - 5\%) = 3\% - 1.5\%$ | 1.5% |
When $u = u^$, actual inflation equals expected inflation $\pi = \pi^e$ — this is the long-run equilibrium. Any attempt to hold $u < u^$ causes $\pi > \pi^e$, which eventually raises $\pi^e$ itself — the short-run Phillips curve shifts up, and the economy ends up with higher inflation at the same unemployment rate.
The Accelerationist Hypothesis: If the government repeatedly tries to hold unemployment below $u^$, inflation doesn’t just stay high — it accelerates. Each round of stimulus raises expected inflation, shifting the SRPC up. The only way to stop accelerating inflation is to let unemployment return to $u^$.
Neoclassical Approach to Unemployment
| Type | Neoclassical View |
|---|---|
| Cyclical unemployment | Temporary — the economy will self-correct; no need for active policy |
| Natural rate of unemployment | The real focus — reduce it through structural reforms |
Neoclassical policies to reduce the natural rate:
- Redesign unemployment and welfare programs to encourage job-hunting
- Simplify business regulations that discourage hiring
- Improve information flow about job openings (better matching workers to jobs)
- Fund retraining programs for structurally unemployed workers
- Invest in education and human capital
Neoclassical Approach to Inflation
Neoclassical economists see no social benefit to inflation:
- With a vertical LRAS, higher AD only pushes prices up — it doesn’t increase output
- Therefore, the government should allow AD to expand only enough to match gradual rightward shifts in AS
- This keeps the price level stable and inflationary pressures low
Summary: Neoclassical Policy Recommendations
- Don’t “fine-tune” the economy — it does more harm than good
- Maintain a stable economic environment with low, predictable inflation
- Keep tax rates low and unchanging so firms can make optimal investment decisions
- Focus government policy on promoting long-run productivity growth: human capital, physical capital, technology, and innovation
- Let market forces handle short-run adjustments
Neoclassical vs. Keynesian: Side-by-Side Comparison
| Dimension | Neoclassical | Keynesian |
|---|---|---|
| Time focus | Long-term | Short-term |
| Prices and wages | Flexible | Sticky |
| Output determined by | Aggregate supply | Aggregate demand |
| AS curve shape | Vertical | Upward-sloping |
| Phillips curve | Vertical (no trade-off) | Downward-sloping (trade-off) |
| AD useful for controlling inflation? | Yes | Yes |
| Policy for unemployment | Reform labor market institutions | Increase AD to eliminate cyclical unemployment |
| AD useful for ending recession? | At best, only temporarily; may just cause inflation | Yes |
3. Balancing Keynesian and Neoclassical Models
The Synthesis
Most mainstream economists today don’t belong to a single camp — they use both perspectives:
Robert Solow (Nobel Prize, 1987) summed it up:
“At short time scales, something sort of ‘Keynesian’ is a good approximation. At very long time scales, the interesting questions are best studied in a neoclassical framework. At the five-to-ten-year time scale, we have to piece things together as best we can, and look for a hybrid model that will do the job.”
| Time Horizon | Best Framework | Focus |
|---|---|---|
| Short run (months to ~2 years) | Keynesian | AD, sticky prices, fighting recessions |
| Medium run (~5–10 years) | Hybrid | Both AD and AS adjustments matter |
| Long run (decades) | Neoclassical | Potential GDP, AS, productivity growth |
Strengths and Weaknesses
| Perspective | Strengths | Weaknesses |
|---|---|---|
| Keynesian | Explains recessions and cyclical unemployment well; provides actionable short-run policy tools | Risks overlooking long-term growth; may underestimate economy’s self-correcting ability |
| Neoclassical | Focuses on fundamental determinants of growth (capital, human capital, technology); explains why unemployment reverts to a natural rate | Not helpful during deep or prolonged recessions (Great Depression, Great Recession); can seem callous about short-run suffering |
Lessons from Recent Recessions
Great Recession (2007–2009):
- Without fiscal policy (TARP, stimulus), GDP decline would have been much worse than the actual 3.3% drop (2008) and 0.1% drop (2009)
- An estimated 8.5 million additional jobs would have been lost without government intervention
- Even neoclassical economists largely acknowledge these policies helped
Pandemic Recession (2020):
- The federal government responded quickly (unlike typical slow policy response) — stimulus checks, PPP loans, expanded unemployment insurance
- The economic fallout would have been far worse without intervention
- However, some economists argue the aggressive stimulus contributed to high inflation starting in mid-2021 — an outcome the neoclassical perspective would predict
- The pandemic also reduced potential GDP by pushing workers out of the labor force (early retirement, health concerns, childcare issues)
4. Key Takeaways
- Neoclassical economics holds that potential GDP determines the economy’s long-run size. Potential GDP depends on physical capital, human capital, and technology.
- Flexible wages and prices self-correct the economy back to potential GDP after any AD shock — but this process takes time (estimated 2–5 years).
- The LRAS curve is vertical at potential GDP — in the long run, AD only affects the price level, not output.
- Rational expectations theory says people use all available information to anticipate outcomes, making adjustment fast. Adaptive expectations theory says people learn gradually from experience, making adjustment slower.
- The long-run Phillips curve is vertical at the natural rate of unemployment — there is no permanent trade-off between inflation and unemployment (Milton Friedman).
- Neoclassical economists are skeptical of active fiscal policy due to recognition, decision, and implementation lags that may cause policy to arrive too late or even make things worse.
- Neoclassical policy focuses on long-run productivity growth and reducing the natural rate of unemployment through institutional reform, not on fighting recessions with demand stimulus.
- Most modern economists use both frameworks: Keynesian for the short run, neoclassical for the long run.
5. Practice Questions
Q1. What are the two building blocks of neoclassical economics? How do they differ from the Keynesian building blocks?
Answer
The two neoclassical building blocks are: (1) potential GDP determines the economy's size in the long run, and (2) wages and prices are flexible, allowing the economy to self-correct back to potential GDP. This contrasts with the Keynesian building blocks: (1) aggregate demand is the primary cause of short-run economic fluctuations, and (2) wages and prices are sticky, preventing the economy from self-correcting quickly.Q2. Explain the neoclassical adjustment process when aggregate demand increases beyond potential GDP. What happens in the short run vs. the long run?
Answer
**Short run:** AD shifts right → equilibrium moves above potential GDP → output rises, prices rise, unemployment falls below the natural rate. **Long run:** The labor shortage causes employers to bid up wages → higher wages increase production costs → SRAS shifts left → output falls back to potential GDP, but the price level is permanently higher. In the neoclassical view, the surge in AD produces only temporary output gains. Its permanent effect is a higher price level (inflation).Q3. What is the difference between rational expectations and adaptive expectations? How does each affect the speed of macroeconomic adjustment?
Answer
**Rational expectations:** People use all available information to form the most accurate possible forecasts. If agents know the LRAS is vertical, they anticipate that AD shifts will only affect prices — so they adjust prices quickly. Result: very fast macroeconomic adjustment (weeks to months). **Adaptive expectations:** People look at past experience and gradually update their beliefs. They may take months or years to fully adjust wages and prices in response to changing conditions. Result: much slower adjustment (years), with the economy spending extended periods below or above potential GDP.Q4. Why is the long-run Phillips curve vertical in the neoclassical model? What does this mean for policymakers?
Answer
The long-run Phillips curve is vertical because the LRAS curve is vertical. If aggregate supply determines output and employment in the long run, then shifts in AD change only the price level — they cannot permanently change the unemployment rate. The economy always returns to the natural rate of unemployment regardless of the inflation rate. For policymakers, this means there is **no permanent trade-off between inflation and unemployment**. Trying to reduce unemployment below the natural rate through expansionary policy will only create inflation, with no lasting employment gains.Q5. List three reasons why neoclassical economists are skeptical of active fiscal policy during a recession.
Answer
1. **Recognition lag:** It takes months to even determine whether a recession is occurring — preliminary GDP data is often revised substantially. 2. **Implementation lag:** The political process of enacting tax cuts or spending increases takes additional months. By the time policy takes effect, the recession may already be over. 3. **Pro-cyclical risk:** If the stimulus arrives when the economy is already recovering, it overheats the economy and causes inflation — making the business cycle worse, not better. Additional reasons include: the average post-WWII recession lasted only about a year (too short for fiscal policy to respond), and political considerations may distort the size and targeting of fiscal policies.Q6. How would a neoclassical economist approach the problem of high unemployment differently from a Keynesian economist?
Answer
A **Keynesian** would identify high unemployment as a symptom of insufficient aggregate demand and prescribe expansionary fiscal policy (tax cuts, spending increases) to shift AD right and close the recessionary gap. A **neoclassical** would distinguish between cyclical and natural unemployment. For cyclical unemployment, they would argue the economy will self-correct as wages and prices adjust. Instead of trying to boost AD, they would focus on reducing the **natural rate of unemployment** through structural reforms: redesigning unemployment benefits to encourage job-hunting, reducing regulations that discourage hiring, improving job-matching services, and funding worker retraining programs.Q7. Suppose the government uses fiscal stimulus aggressively to maintain 2% unemployment (well below the natural rate of 5%). What does neoclassical theory predict will happen?
Answer
Neoclassical theory predicts this policy will fail and cause persistent inflation: - Keeping the economy above potential GDP requires continually pushing AD to the right - Each rightward shift of AD moves the equilibrium further up the vertical LRAS curve, raising the price level - Meanwhile, the labor shortage will drive up wages, shifting SRAS left and adding further inflationary pressure - The economy cannot sustain production above potential GDP permanently - In the long run, the only result is a much higher price level (inflation) with unemployment returning to the natural rate of 5% anywayQ8. Robert Solow described macroeconomics as requiring a “hybrid model.” What did he mean, and why is this hybrid approach necessary?
Answer
Solow meant that neither the Keynesian nor the neoclassical perspective alone can explain the economy across all time horizons: - **Short run (months to ~2 years):** Keynesian analysis works better — aggregate demand fluctuations, sticky wages/prices, and the potential for prolonged recessions are real phenomena - **Long run (decades):** Neoclassical analysis works better — potential GDP, productivity growth, and flexible prices determine the economy's size - **Medium run (5–10 years):** Both forces are at work, and economists need hybrid models A pure Keynesian approach risks ignoring long-term growth fundamentals. A pure neoclassical approach risks dismissing real short-run suffering during recessions. The hybrid approach acknowledges that both aggregate demand and aggregate supply matter, just over different time horizons.Q9. The 2020 pandemic response was unusually fast — stimulus checks, PPP loans, and expanded unemployment insurance were enacted within weeks. Does this address the neoclassical critique of fiscal policy? What concerns might remain?
Answer
Yes, the rapid 2020 response addressed one key neoclassical critique — that fiscal policy arrives too slowly. The government acted within weeks rather than months or years, and there is broad agreement that the policies prevented much worse economic outcomes. However, neoclassical concerns still apply: - Some economists argue the government **over-stimulated** — the aggressive fiscal intervention may have pushed AD above potential GDP, contributing to the high inflation that began in mid-2021 - The pandemic also reduced **potential GDP** itself (workers leaving the labor force due to health concerns, early retirement, childcare issues), which is exactly the kind of supply-side factor neoclassicals emphasize - The neoclassical perspective correctly predicted that stimulus beyond what the economy could produce would result in inflation, not additional real outputQ10. Use the following data to identify the natural rate of unemployment and sketch both the short-run and long-run Phillips curves:
| Year | Inflation | Unemployment |
|---|---|---|
| 1970 | 2% | 4% |
| 1975 | 3% | 3% |
| 1980 | 2% | 4% |
| 1985 | 1% | 6% |
| 1990 | 1% | 4% |
Answer
The natural rate of unemployment appears to be **4%** — the economy keeps returning to this rate after temporary deviations. - **1975:** AD increased → unemployment fell to 3% but inflation rose to 3% (short-run movement along downward-sloping Phillips curve) - **1980:** Economy adjusted back to 4% unemployment, inflation returned to 2% (returned to natural rate) - **1985:** AD decreased → unemployment rose to 6%, inflation fell to 1% (opposite movement along short-run Phillips curve) - **1990:** Economy adjusted back to 4% unemployment The **short-run Phillips curve** traces downward-sloping patterns between consecutive data points. The **long-run Phillips curve** is a vertical line at 4% unemployment — the economy always returns to this rate regardless of the inflation rate.Q11. Using the expectations-augmented Phillips curve $\pi = \pi^e - \beta(u - u^)$ with $\beta = 0.6$ and $u^ = 5\%$:
(a) If expected inflation is 2% and actual unemployment is 3%, what is the actual inflation rate?
(b) The government keeps unemployment at 3%. After a year, people revise $\pi^e$ upward to match last period’s actual inflation. What is the new inflation rate?
(c) Show that repeating this process produces accelerating inflation.
Answer
**(a)** $\pi = 2\% - 0.6(3\% - 5\%) = 2\% + 1.2\% = 3.2\%$ **(b)** People revise $\pi^e = 3.2\%$. With $u$ still at 3%: $\pi = 3.2\% - 0.6(3\% - 5\%) = 3.2\% + 1.2\% = 4.4\%$ **(c)** Each round: - Round 1: $\pi^e = 2\% \to \pi = 3.2\%$ - Round 2: $\pi^e = 3.2\% \to \pi = 4.4\%$ - Round 3: $\pi^e = 4.4\% \to \pi = 5.6\%$ - Round 4: $\pi^e = 5.6\% \to \pi = 6.8\%$ Inflation accelerates by $+1.2\%$ each period. The general pattern: $\pi_t = \pi_0^e + t \times \beta(u^* - u) = 2\% + t \times 1.2\%$. This is the **accelerationist hypothesis** — holding unemployment below the natural rate doesn't just create inflation, it creates *accelerating* inflation. Only returning $u$ to $u^* = 5\%$ stops the spiral.Q12. An economy starts at potential GDP ($Y^* = 1{,}000$, $P = 100$). The government increases spending, shifting AD right. In the short run, output rises to 1,060 and the price level rises to 108.
(a) Calculate the percentage output gap and the inflation rate.
(b) Using the neoclassical self-correction model, explain what happens next. If wages rise by 5% in response and SRAS shifts left until output returns to 1,000, what is the new long-run price level?
(c) Was the fiscal stimulus successful from a neoclassical perspective? A Keynesian perspective?
Answer
**(a)** Output gap: $\frac{1{,}060 - 1{,}000}{1{,}000} \times 100 = 6\%$ above potential. Inflation: $\frac{108 - 100}{100} \times 100 = 8\%$. **(b)** With output 6% above potential: - Labor markets tighten → wages bid up by 5% - Higher wages shift SRAS left - Output falls back toward $Y^* = 1{,}000$ - Price level rises further as SRAS shifts left - New long-run equilibrium: $Y = 1{,}000$, $P \approx 113$ (the AD₁ curve intersects LRAS at a higher price level) The full effect of the spending increase: **zero permanent output gain** and a **13% higher price level**. **(c)** - **Neoclassical view:** The stimulus was counterproductive. It temporarily boosted output but ultimately only produced inflation. The self-correcting mechanism would have returned the economy to potential GDP anyway. - **Keynesian view:** If the economy was in recession (output below 1,000), the stimulus was appropriate for closing the output gap — preventing unemployment and lost output in the short run. The Keynesian would argue the 6% gap closure was valuable even if temporary.Q13. Case Study — The Volcker Disinflation (1979–1983):
When Paul Volcker became Fed Chair in 1979, inflation was running at 13.3% and expected inflation was similarly high. He raised the federal funds rate to 20%, deliberately pushing unemployment to 10.8% (1982) — well above the natural rate of ~6%.
(a) Using $\pi = \pi^e - 0.5(u - u^*)$, calculate the expected inflation effect of pushing unemployment from 6% to 10.8% in the first year (assume $\pi^e = 13.3\%$).
(b) By 1983, inflation had fallen to 3.2%. Using the Phillips curve framework, explain the mechanism — why did actual inflation fall so far?
(c) Calculate the sacrifice ratio: the cumulative percentage points of excess unemployment per percentage point of inflation reduction. Is this consistent with the neoclassical view?
Answer
**(a)** $\pi = 13.3\% - 0.5(10.8\% - 6\%) = 13.3\% - 2.4\% = 10.9\%$ So in the first year, inflation would fall from 13.3% to about 10.9% — a meaningful but not dramatic reduction. **(b)** The mechanism over 1979–1983: 1. Tight monetary policy → AD contracts → unemployment rises far above $u^*$ 2. With $u \gg u^*$, actual inflation falls below expected inflation each period 3. Workers and firms gradually **revise $\pi^e$ downward** (adaptive expectations) 4. As $\pi^e$ falls, the SRPC shifts down, allowing further inflation reduction 5. By 1983: $\pi^e$ had fallen dramatically → $\pi = 3.2\%$ The key insight: reducing entrenched inflation expectations requires a **sustained period** of unemployment above the natural rate. There is no painless way to disinflate. **(c)** Sacrifice ratio calculation: - Inflation reduction: $13.3\% - 3.2\% = 10.1$ percentage points - Excess unemployment (above $u^* \approx 6\%$): roughly 4.8 pp × 4 years = ~19.2 percentage-point-years - Sacrifice ratio: $\frac{19.2}{10.1} \approx 1.9$ This means each percentage point of inflation reduction cost about 1.9 percentage-point-years of excess unemployment. The neoclassical view (rational expectations) would predict a **lower** sacrifice ratio if the Fed's commitment were credible — people would adjust expectations faster. The actual ratio of ~1.9 suggests expectations were more adaptive than rational, consistent with the 2–5 year adjustment estimate.6. Glossary
| Term | Definition |
|---|---|
| Neoclassical perspective | The view that, in the long run, the economy fluctuates around potential GDP and the natural rate of unemployment; aggregate supply determines output |
| Potential GDP | The level of output achievable when all resources (labor, capital, technology) are fully employed |
| Physical capital per person | The amount and quality of machinery and equipment available to help each worker produce goods and services |
| LRAS (Long-Run Aggregate Supply) | A vertical line at potential GDP; shows that long-run output is independent of the price level |
| Rational expectations | The theory that people form the most accurate possible expectations about the future using all available information; implies very fast price adjustment |
| Adaptive expectations | The theory that people look at past experience and gradually adjust beliefs and behavior; implies slower price adjustment |
| Expected inflation | The future rate of inflation that consumers and firms build into current decision-making (wage negotiations, loan terms, pricing) |
| Natural rate of unemployment | The unemployment rate that prevails when the economy is at potential GDP; includes frictional and structural but not cyclical unemployment |
| Long-run Phillips curve | A vertical line at the natural rate of unemployment; shows no permanent trade-off between inflation and unemployment |
| Self-correction | The neoclassical mechanism by which flexible wages and prices guide the economy back to potential GDP after an AD shock |