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4.3 The Expectations-augmented Phillips Curve Analysis

The second stage in the development of orthodox monetarism came with a

more precise analysis of the way the effects of changes in the rate of monetary

expansion are divided between real and nominal magnitudes. This

analysis involved the independent contributions made by Friedman (1968a)

and Phelps (1967, 1968) to the Phillips curve literature (see Chapter 3,

The orthodox monetarist school 175

section 3.6). The notion of a stable relationship between inflation and unemployment

was challenged by Friedman and Phelps, who both denied the

existence of a permanent (long-run) trade-off between inflation and unemployment

(Phelps’s analysis originated from a non-monetarist perspective;

see Cross, 1995). The problem with the original specification of the Phillips

curve is that the rate of change of money wages is determined quite independently

of the rate of inflation. This in turn implies that workers are

irrational and suffer from complete money illusion, in that they base their

labour supply decisions on the level of money wages quite independently of

what is happening to prices. In what follows we focus on the highly influential

arguments put forward by Friedman (1968a) in his 1967 Presidential

Address to the American Economic Association. Before doing so we should

recognize just how important Friedman’s paper proved to be for the development

of macroeconomics after 1968. While A Monetary History has

undoubtedly been Friedman’s most influential book in the macroeconomics

sphere, his 1967 Presidential Address published as ‘The Role of Monetary

Policy’ has certainly been his most influential article. In 1981 Robert Gordon

described this paper as probably the most influential article written in macroeconomics

in the previous 20 years. James Tobin (1995), one of Friedman’s

most eloquent, effective and long-standing critics, went even further, describing

the 1968 paper as ‘very likely the most influential article ever published

in an economics journal’ (emphasis added). Paul Krugman (1994a) describes

Friedman’s paper as ‘one of the decisive intellectual achievements of postwar

economics’ and both Mark Blaug (1997) and Robert Skideksky (1996b)

view it as ‘easily the most influential paper on macroeconomics published in

the post-war era’. Between 1968 and 1997 Friedman’s paper has approximately

924 citation counts recorded by the Social Sciences Citation Index

and it continues to be one of the most heavily cited papers in economics (see

Snowdon and Vane, 1998). Friedman’s utilization of Wicksell’s concept of

the ‘natural rate’ in the context of unemployment was in rhetorical terms a

‘masterpiece of marketing’ (see Dixon, 1995), just as the application of the

term ‘rational’ to the expectations hypothesis turned out to be in the rise of

new classical economics during the 1970s. The impact of Professor Friedman’s

work forced Keynesians to restate and remake their case for policy

activism even before that case was further undermined by the penetrating

theoretical critiques of Professor Lucas and other leading new classical economists.

4.3.1 The expectations-augmented Phillips curve

The prevailing Keynesian view of the Phillips curve was overturned by new

ideas hatched during the 1960s and events in the 1970s (Mankiw, 1990). A

central component of the new thinking involved Friedman’s critique of the

trade-off interpretation of the Phillips curve. This was first provided by Friedman

(1966) in his debate with Solow (1966) over wage and price guideposts

and had even been outlined much earlier in conversation with Richard Lipsey

in 1960 (Leeson, 1997a). However, the argument was developed more fully

in his famous 1967 Presidential Address. According to Friedman, the original

Phillips curve which related the rate of change of money wages to unemployment

was misspecified. Although money wages are set in negotiations, both

employers and employees are interested in real, not money, wages. Since

wage bargains are negotiated for discrete time periods, what affects the

anticipated real wage is the rate of inflation expected to exist throughout the

period of the contract. Friedman argued that the Phillips curve should be set

in terms of the rate of change of real wages. He therefore augmented the

basic Phillips curve with the anticipated or expected rate of inflation as an

additional variable determining the rate of change of money wages. The

expectations-augmented Phillips curve can be expressed mathematically by

the equation:

f (U) P˙ e (4.2)

Equation (4.2) shows that the rate of money wage increase is equal to a

component determined by the state of excess demand (as proxied by the level

of unemployment) plus the expected rate of inflation.

Introducing the expected rate of inflation as an additional variable to excess

demand which determines the rate of change of money wages implies

that, instead of one unique Phillips curve, there will be a family of Phillips

curves, each associated with a different expected rate of inflation. Two such

curves are illustrated in Figure 4.4. Suppose the economy is initially in

equilibrium at point A along the short-run Phillips curve (SRPC1) with unemployment

at UN, its natural level (see below) and with a zero rate of increase

of money wages. For simplification purposes in this, and subsequent, analysis

we assume a zero growth in productivity so that with a zero rate of money

wage increase the price level would also be constant and the expected rate of

inflation would be zero; that is, W˙ P˙ e 0 per cent. Now imagine the

authorities reduce unemployment from UN to U1 by expanding aggregate

demand through monetary expansion. Excess demand in goods and labour

markets would result in upward pressure on prices and money wages, with

commodity prices typically adjusting more rapidly than wages. Having recently

experienced a period of price stability (P˙ e 0), workers would

misinterpret their money wage increases as real wage increases and supply

more labour; that is, they would suffer from temporary money illusion. Real

wages would, however, actually fall and, as firms demanded more labour,

unemployment would fall, with money wages rising at a rate of W˙1, that is,

The orthodox monetarist school 177

point B on the short-run Phillips curve (SRPC1). As workers started slowly to

adapt their inflation expectations in the light of the actual rate of inflation

experienced (P˙ W˙1), they would realize that, although their money wages

had risen, their real wages had fallen, and they would press for increased

money wages, shifting the short-run Phillips curve upwards from SRPC1 to

SRPC2. Money wages would rise at a rate of ˙W1 plus the expected rate of

inflation. Firms would lay off workers as real wages rose and unemployment

would increase until, at point C, real wages were restored to their original level,

with unemployment at its natural level. This means that, once the actual rate of

inflation is completely anticipated (P˙ P˙ e )

1 in wage bargains (W˙ P˙ , e

1 that is

to say there is no money illusion), there will be no long-run trade-off between

unemployment and wage inflation. It follows that if there is no excess demand

(that is, the economy is operating at the natural rate of unemployment),

then the rate of increase of money wages will equal the expected rate of

inflation and only in the special case where the expected rate of inflation is

zero will wage inflation be zero, that is, at point A in Figure 4.4. By joining

points such as A and C together, a long-run vertical Phillips curve is obtained

at the natural rate of unemployment (UN). At UN the rate of increase in money

wages is exactly equal to the rate of increase in prices, so that the real wage is

constant. In consequence there will be no disturbance in the labour market.

At the natural rate the labour market is in a state of equilibrium and the actual

and expected rates of inflation are equal; that is, inflation is fully anticipated.

Figure 4.4 The expectations-augmented Phillips curve

Friedman’s analysis helped reconcile the classical proposition with respect to

the long-run neutrality of money (see Chapter 2, section 2.5), while still

allowing money to have real effects in the short run.

Following Friedman’s attack on the Phillips curve numerous empirical

studies of the expectations-augmented Phillips curve were undertaken using

the type of equation:

f (U) P˙ e (4.3)

Estimated values for of unity imply no long-run trade-off. Conversely

estimates of of less than unity, but greater than zero, imply a long-run

trade-off but one which is less favourable than in the short run. This can be

demonstrated algebraically in the following manner. Assuming a zero growth

in productivity so that W˙ P˙, equation (4.3) can be written as:

f (U) P˙ e (4.4)

Rearranging equation (4.4) we obtain:

P˙ −P˙ e f (U) (4.5)

Starting from a position of equilibrium where unemployment equals U* (see

Figure 4.5) and the actual and expected rates of inflation are both equal to

zero (that is, P˙ P˙ e ), equation (4.5) can be factorized and written as:

P˙(1−) f (U) (4.6)

Finally, dividing both sides of equation (4.6) by 1 – , we obtain

˙ ( )


f U



Now imagine the authorities initially reduce unemployment below U* (see

Figure 4.5) by expanding aggregate demand through monetary expansion.

From equation (4.7) we can see that, as illustrated in Figure 4.5, (i) estimated

values for of zero imply both a stable short- and long-run trade-off between

inflation and unemployment in line with the original Phillips curve; (ii)

estimates of of unity imply no long-run trade-off; and (iii) estimates of of

less than unity, but greater than zero, imply a long-run trade-off but one

which is less favourable than in the short run. Early evidence from a wide

range of studies that sought to test whether the coefficient () on the inflation

expectations term is equal to one proved far from clear-cut. In consequence,

The orthodox monetarist school 179

Figure 4.5 The trade-off between inflation and unemployment

during the early 1970s, the subject of the possible existence of a long-run

vertical Phillips curve became a controversial issue in the monetarist–

Keynesian debate. While there was a body of evidence that monetarists could

draw on to justify their belief that equals unity, so that there would be no

trade-off between unemployment and inflation in the long run, there was

insufficient evidence to convince all the sceptics. However, according to one

prominent American Keynesian economist, ‘by 1972 the “vertical-in-thelong-

run” view of the Phillips curve had won the day’ (Blinder, 1992a). The

reader is referred to Santomero and Seater (1978) for a very readable review

of the vast literature on the Phillips curve up to 1978. By the mid- to late

1970s, the majority of mainstream Keynesians (especially in the USA) had

come to accept that the long-run Phillips curve is vertical. There is, however,

still considerable controversy on the time it takes for the economy to return to

the long-run solution following a disturbance.

Before turning to discuss the policy implications of the expectations-augmented

Phillips curve, it is worth mentioning that in his Nobel Memorial

Lecture Friedman (1977) offered an explanation for the existence of a positively

sloped Phillips curve for a period of several years, which is compatible

with a vertical long-run Phillips curve at the natural rate of unemployment.

Friedman noted that inflation rates tend to become increasingly volatile at

higher rates of inflation. Increased volatility of inflation results in greater

uncertainty, and unemployment may rise as market efficiency is reduced and

the price system becomes less efficient as a coordinating/communication mechanism

(see Hayek, 1948). Increased uncertainty may also cause a fall in investment

and result in an increase in unemployment. Friedman further argued that, as

inflation rates increase and become increasingly volatile, governments tend to

intervene more in the price-setting process by imposing wage and price controls,

which reduces the efficiency of the price system and results in an increase

in unemployment. The positive relationship between inflation and unemployment

then results from an unanticipated increase in the rate and volatility of

inflation. While the period of transition could be quite long, extending over

decades, once the economy had adjusted to high and volatile inflation, in

Friedman’s view, it would return to the natural rate of unemployment.