Financial-markets commentators and policy-makers should do the same. Inflation took center stage at the recent confirmation hearing for Federal Reserve chairman Jerome Powell. “High inflation is a severe threat to the achievement of maximum employment,” Powell told members of the Senate Banking Committee. “To get the kind of very strong labor market we want with high participation, it’s going to take a long expansion . . . and to get a long expansion, we’re going to need price stability.”
Powell’s remarks left some commentators scratching their heads. The traditional economic theory, based on what is known as the “Phillips curve,” takes there to be a trade-off between inflation and unemployment: In order to bring down inflation, the Fed must tighten monetary policy — thereby reducing output and employment. Powell appears to deny this trade-off. By lowering inflation, he says, the Fed will bolster the labor market as well.
Despite claims to the contrary, Powell’s view is very much in line with current macroeconomic theory — and has been for some time. Economists dropped the naïve Phillips-curve view decades ago. Financial-markets commentators and policy-makers should do the same.
The Birth of a Bad Idea
When John Maynard Keynes published The General Theory of Employment, Interest, and Money in 1936, he introduced a set of ideas that would dominate macroeconomics for the next four decades. At the outset, however, the Keynesian consensus lacked a theory of inflation. Keynes had discarded the quantity theory of money — which linked inflation to the growth rate of money — in order to make room for his liquidity-preference theory. The early Keynesian model, therefore, could not explain inflation.
The first step toward developing a Keynesian theory of inflation came in 1958, when A. W. Phillips identified a negative relationship between the growth rate of nominal (or, money) wages and unemployment in the United Kingdom. Other Keynesian economists — including Paul Samuelson and Robert Solow — took notice. They recognized the model’s deficiency and correctly guessed that the growth rate of nominal wages would be highly correlated with inflation. In 1960, Samuelson and Solow identified a negative relationship between inflation and unemployment, which came to be known as the Phillips curve.
Samuelson and Solow’s finding was an empirical observation but came to be treated as a theoretical given. In the 1960s and early 1970s, most economists believed there was a stable, exploitable trade-off between inflation and unemployment. The Phillips curve represented a menu of policy options: Policy-makers could achieve a lower unemployment rate so long as they were willing to put up with higher inflation, and vice versa. By treating inflation as a policy choice, the Phillips curve filled a significant gap in the Keynesian model.
The Critics and Correction
Notably absent from the Keynesian Phillips curve was a reasonable assumption about expectations. Higher inflation means that firms can afford to pay workers a higher nominal wage. The Keynesians implicitly assumed that an unemployed person would be more inclined to accept a position that pays a higher nominal wage, even if higher prices meant that the amount of real goods and services he or she would be able to purchase with that wage remained the same. Rather than assuming people might anticipate inflation and build expected price changes into their reservation wage (the lowest rate they are willing to accept to perform a given job), the Keynesians thought that one might be consistently fooled into working by the payment of more less-valuable money.
In his 1968 presidential address to the American Economic Association, Milton Friedman took the Keynesians to task. The decision to work does not depend on the amount of money firms offer, Friedman argued, but on the amount of goods and services that money can buy. People will agree to work only if the real — or, inflation-adjusted — wage is sufficiently high. A sudden bout of high inflation might temporarily fool some into accepting job offers, but the fooled workers would soon realize that the money they agreed to accept could not purchase as many goods and services as expected. Once this becomes clear, they will quit the jobs that they were duped into taking, and the unemployment rate will climb back up to where it was beforehand.
By supposing there is a natural rate of unemployment to which an economy ultimately converges, Friedman denied the existence of an exploitable trade-off between inflation and unemployment beyond some short period of time in which people might be fooled. He and fellow economist Edmund Phelps predicted that the negative relationship between inflation and unemployment identified in the data would break down if policy-makers treated the Phillips curve as a menu of policy options. Indeed, Friedman thought higher inflation might ultimately bring about a higher unemployment rate, since higher rates of inflation make it more difficult to produce.
The predictions of Friedman and Phelps proved prescient. Contrary to the Phillips-curve view, which supposed higher inflation would coincide with lower unemployment, stagflation in the 1970s saw both inflation and unemployment increase simultaneously. The Keynesian consensus, struggling to explain this phenomenon, was ultimately swept aside. And new macroeconomic models were built on the idea that people cannot be systematically fooled by policy-makers.
Modern Macroeconomics
Very few economists believe there is a stable, exploitable trade-off between inflation and unemployment today. Undergraduate students might encounter a Phillips curve in their macroeconomics textbook, but it won’t be the naïve Phillips curve of old. Instead, it will be an expectations-augmented Phillips curve, which shifts up and down with inflation expectations to trace the natural rate of unemployment at each inflation rate, just as Friedman and Phelps recommended.
Much the same can be said about the more-sophisticated models that professional economists employ. The standard New Keynesian model has little in common with its old Keynesian predecessor. Agents in the New Keynesian model are assumed to have rational expectations, preventing them from being duped by policy-makers. And the model is characterized by what Olivier Blanchard and Jordi Galí have called the “divine coincidence”: that there is no trade-off between stabilizing inflation and minimizing the gap between actual and efficient output. It assumes, in other words, that the economy ultimately settles on the natural rate of unemployment.
Conclusion
Far from being unconventional, Chairman Powell’s view on inflation and unemployment is the norm among economists. He understands that high rates of inflation are costly and that the Fed can do little to push unemployment below the natural rate. Although the naïve Phillips-curve view was once fashionable, it is rightfully met with a snicker among economists today. It is the pastel bell-bottom leisure suit of economic ideas.
Bryan Cutsinger is an assistant professor of economics in the Norris-Vincent College of Business and a research assistant professor at the Free Market Institute at Texas Tech University. William J. Luther is an associate professor of economics at Florida Atlantic University and the director of the Sound Money Project at the American Institute for Economic Research.