Milton Friedman and the Trade-Off That Wasn't

This article records tradition as it has been passed down and reported. Its sources are not yet part of the atlas's verified catalogue.

By the late 1960s, governments across the developed world had spent a decade treating the Phillips Curve as a dial they could turn, choosing a little more inflation in exchange for a little less unemployment. In his 1968 presidential address to the American Economic Association, Milton Friedman argued the dial was an illusion. His reasoning turned on expectations: the original trade-off worked, he argued, only because workers and firms were repeatedly surprised by inflation they had not anticipated when they set wages and prices. Surprise inflation temporarily makes real wages look lower to employers, so they hire more, unemployment falls, but once workers and firms come to expect the going rate of inflation and build it into their wage bargains, the same nominal inflation no longer fools anyone and unemployment reverts to what Friedman called its natural rate, the rate consistent with the economy's underlying structure regardless of the inflation rate. Edmund Phelps developed a closely related argument at nearly the same time. The prediction was tested within a decade: the stagflation of the 1970s, simultaneous high inflation and high unemployment, was exactly the kind of outcome the original stable Phillips Curve said should not happen, and it reshaped how central banks think about the limits of demand management ever since.