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Sunday, April 8, 2012

33. The Phillips Curve

The Concise Guide To Economics

by Jim Cox

33. The Phillips Curve

The Phillips Curve asserts a permanent trade-off between unemployment and inflation based on empirical data and the strict Keynesian theory that an economy can suffer either from inflation or unemployment problems but never both simultaneously.  In fact, there is no permanent or long-term trade-off between the two. 
The only reason that a temporary or short-term trade-off does occur is because of a lack of understanding of actual conditions by workers.  When inflation unexpectedly increases, workers are caught off guard and continue to engage in a job search based on a now-mistaken understanding of the value of money.  Once workers realize that inflation has undermined the value of money they then adjust their wage requirements upward to compensate for the reduced dollar value and thereby lengthen the duration of the job search and increase the unemployment rate itself.   
The reverse occurs in times of disinflation (consecutively lower rates of inflation).  A temporary or short-term tradeoff results from workers being caught off guard as they now seek unrealistic wage rates.  Once workers realize that inflation is not undermining the value of money as rapidly as they had anticipated, they lower their wage expectations thereby shortening the duration of the job search and reducing the unemployment rate.
The recent statistics demonstrate the truth of the above as inflation and unemployment increased during the 1970's and then both decreased during the 1980's:
Interestingly, Milton Friedman postulated the correct understanding of a short-term tradeoff of inflation and unemployment in the mid-60's when the Phillips Curve notion of a permanent tradeoff was considered holy writ by most economists. Even more amazing is that Ludwig von Mises anticipated both the faulty and the correct theories in 1952!
By tying the theory to actual individual micro-decisions, Friedman and Mises applied the correct methodology.  In contrast, the Keynesians, believing that the aggregate "inflation" and the aggregate "unemployment" somehow acted directly on one another, failed to tie all economic questions to individual behavior and therefore misled an entire generation.
Concise Guide to Economics, The

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