Keynes’s explanation for persistent unemployment

As we have seen, Keynes’s explanation for persistent unemployment was that the prevailing level of real wages was not compatible with labor market clearing and instead produced excess supply of labor. This fact raised the question of why lower, market-clearing real wages could not be produced by reductions in nominal wages. One explanation frequently offered was that workers would oppose nominal wage reductions. Friedman (1976) was very skeptical about this and other explanations that Keynesians put forward to explain supposed nominal wage rigidities. He was willing to concede that there might be some situations in which wages and salaries were rigid; the legal minimum wage, he noted, was an example of such a rigidity. He argued, however, that situations like these were the exception rather than the rule. In most industries, he pointed out, relatively few workers earned the minimum wage: what prevented workers in these industries from reducing their wage requests in order to avoid layoffs? And while unions could conceivably be a fac- tor delaying wage adjustment because of their reluctance to accept wage cuts that would benefit unemployed work- ers at union members’ expense, he did not believe that unions were powerful or perverse enough to keep wages from adjusting to full employment levels in the long run.

A second criticism Friedman raised was that researchers had not been able to construct “decent” empirical Phillips curves for the United States or other countries. In later years this problem got worse, and even ardent Keynesians were forced to acknowledge the weak- ness of the empirical evidence supporting the existence of stable national Phillips curves. In 1980, for example, prominent Keynesian Arthur Okun, commenting on the U.S. case, wrote that “since 1970, the Phillips curve has been an unidentified flying object and has eluded all econometric efforts to nail it down” (1980, 166).

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Friedman’s third criticism was outlined in the previ- ous section: Phillips’s statistical evidence involved nomi- nal wages, but standard economic theory assumes that households and firms base their employment decisions on real wages. Clearly, Phillips and his successors were assuming that changes in current nominal wages were equivalent to changes in expected future real wages. This assumption, Friedman noted, really amounted to two assumptions. The first was that prices, or at least price expectations, were rigid: people did not expect the price level to change and consequently interpreted changes in



6. Believers in cost-push inflation often identified unions as one of its main sources. Samuelson and Nordhaus point out, howev- er, that “this view of unions as the clear-cut villain of cost-push inflation does not fit the complex historical facts. Take as an example the depressed year of 1982, when unemployment averaged 9.7 percent of the labor force. During that year, labor costs for union workers rose 7.2 percent, and the cost of nonunion workers rose 6 percent. Both union and nonunion wages rose smartly in spite of high unemployment” (1989, 326).

7. Friedman defines the natural rate of unemployment as the level of unemployment “that would be ground out by the Walrasian system of general equilibrium equations, provided there is imbedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor availabilities, the cost of mobility, and so on” (1968, 8).

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their nominal wages as changes in their real wages. The second assumption was that workers would not resist reductions in their real wages that were caused by infla- tion rather than by reductions in their nominal wages. Only if both assumptions were true could the relationship between the rate of change in nominal wages and the aggregate level of unemployment be stable enough to then offer policymakers a usable menu of options.

A closely related argument made by both Friedman (1968) and Phelps (1967) involved the long-run implica- tions of the Phillips curve. In order to make this argument, they imagined a situation in which a policymaker was try- ing to use the hypothesized inflation-unemployment trade-off to achieve a lasting reduction in the unem- ployment rate. Such a policymaker, they argued, would find that while there might indeed be an inflation- unemployment trade-off in the short run, the trade-off would disappear in the long run. In the long run, they asserted, unemployment tended to return to a “natural rate” (NR) that was determined by real economic forces.7

Monetary policy, in their view, could do nothing to change the natural rate.

The analysis presented by Friedman and Phelps, which was later summarized by Friedman (1976), involved the relationship between real wages and unex- pected inflation. The emphasis on unexpected inflation reflected an attempt on the part of Friedman and Phelps to reconcile the classical principle that labor supply behavior depends on the real wage with Keynes’s obser- vation that workers respond differently to different types of real wage decreases: “Every trade union,” Keynes writes, “will put up some resistance to a cut in money- wages, however small, . . . but no trade union would dream of striking on every occasion of a rise in the cost of living” (1964, 14-15). According to Friedman, this differential response is due to temporary money illusion: it takes time for workers to recognize that the price level has increased, and until they do so they do not realize that their real wage rates have fallen.

Friedman’s discussion can be interpreted as an implicit description of the following hypothetical sequence of events. Suppose the economy starts out in its long-run equilibrium at its normal inflation rate and its natural rate of unemployment. This equilibrium is dis- turbed when a monetary expansion increases households’

aggregate demand for goods and services at current prices. Demand curves will shift to the right throughout the economy, and the market prices of (output) goods and services will rise. The increased market prices of goods will cause the aggregate demand curve for labor, plotted against the nominal wage, to shift to the right.

If workers realize that the price level has increased, then their aggregate labor supply curve will shift to the left, as depicted in the shift from curve D to curve D1 in Chart 2. Equilibrium will be restored at a higher nominal wage rate but at unchanged levels of employment, out- put, and real wages. If workers do not realize that the price level has increased—that is, if the increase in prices is both unperceived a n d u n e x p e c t e d — then employment and nominal wage rates will increase along the old labor supply curve. Workers will now be providing more labor than they would be willing to provide at the current real wage if they knew what that wage really was. At some point, however, workers will figure out that the price level has increased, and the aggregate labor supply curve will begin shifting to the left, as depicted in the shift from curve S to S1 in Chart 2. The shift in the supply curve will drive nominal wages up further. As nominal wages rise, the supply curves for goods and services will shift to the left, driving the price level up further, and so on. Nominal wages will rise faster than prices, however, as workers catch on to the successive price increases. Eventually a new long-run equilibrium is reached at the original unemployment rate (the natural rate) and the original level of real wages— the point L0 in Chart 2. Notice that once the process of adjustment to the new long-run equilibrium gets started, prices lead wages upward rather than the reverse.

To summarize, Friedman and Phelps argued that unexpected inflation can drive the level of unemployment

Keynesian theory implies that government policies can have large, important effects on the economy and that if the policies are carefully devised these effects can be very con- structive in nature.



10 Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 1997

below the natural rate, but only temporarily. In the long run, the surprise factor will disappear as workers learn that the price level has increased; as a result, the level of employment will go back to the natural rate. Thus, in the long run there will be no inflation-unemployment trade-off. Stated differently, the long-run Phillips curve is vertical.

At this point, it is necessary to make some important distinctions regarding the term inflation. A one-time increase in the price level is sometimes called inflation, but it is very different from a situation in which the price level is increasing over time at a constant rate. Both these situations, moreover, are different from one in which the price level is increasing over time at a rate that is also increasing over time (so that the price level is accelerating upward). The inflation that the Keynesian economists who developed Phillips curve analysis had in mind was the type in which the price level increases at a fixed rate. These economists believed that from the point of view of policymakers, the cost of achieving a lower level of unemployment was that the price level would now increase at a higher rate. Inflation would remain constant at this new, higher rate as long as the unemployment rate remained at its new, lower level.

According to Friedman and Phelps, the actual rela- tionship between inflation and unemployment was quite different. In their minds, at least, the difference between their view of this relationship and the Keynesian view involved the way in which workers were assumed to form their expectations. In describing the difference between his view of this process and the view he attributes to Phillips, Friedman quotes Abraham Lincoln’s famous assertion that “you can fool all of the people some of the

time, you can fool some of the people all of the time, but you can’t fool all of the people all of the time” (1976, 231). To Friedman, Phillips’s analysis made sense only if work- ers could be fooled all the time—only, that is, if a given increase in the price level (beyond some unspecified base inflation rate) always fooled workers to exactly the same extent, regardless of how many times they had been fooled previously. Thus, persistent increases in the price level could hold the labor supply curve fixed in a location to the right of its no-surprises position, producing lower unemployment. Higher inflation rates, moreover, shifted the curve further than lower inflation rates and thus pro- duced lower levels of unemployment.

Friedman and Phelps, in contrast, thought that while it might be possible to fool all the workers some of the time (temporarily), it was not possible to fool all of them all of the time (permanently). Eventually, workers would recognize that the base rate of inflation had increased, at which point the labor supply curve would begin to shift back and the increased inflation rate would gradually lose its power to reduce the unemployment rate. Further declines in unemployment could then be achieved, if at all, only by further increases in the rate of inflation. Thus, “the only way unemployment can be kept below the natural rate is by an ever-accelerating infla- tion, which always keeps current inflation ahead of antic- ipated inflation” (Friedman 1976, 227).

The view underlying this “acceleration hypothesis” is that while agents cannot be permanently fooled by infla- tion at a fixed rate, they can be fooled persistently, if not permanently, by accelerating inflation. One reason to be skeptical about this story is evidence from economies that have experienced hyperinflations (extremely rapid

Friedman and Phelps argued that unexpected inflation can drive the level of unemployment below the natural rate, but only temporarily.

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