What happens to unemployment in the long run after a negative demand shock?

• A. Unemployment remains above natural rate permanently.
• B. Unemployment falls below natural rate in the long run.
• C. Unemployment returns to the natural rate as the economy adjusts.
• D. Unemployment becomes unpredictable.

Answer: (C)

In the long run, unemployment returns to the natural rate as prices and wages adjust. A negative demand shock lowers output and the price level in the short run, so unemployment rises above the natural rate. But over time, wages and prices adjust, real balances shift, and production moves back toward potential output. With demand still insufficient to keep unemployment above that level, the structure of the labor market (frictional unemployment, matching efficiency, etc.) sets unemployment at the natural rate again. So long-run unemployment is determined by those structural factors, not by the demand shock itself.