Milton Friedman Prize Lecture

M. Friedman

269

this issue or of the evidence that has led to the revision of the hypothesis. I

shall be able only to skim the surface in the hope of conveying the flavor of

that work and that evidence and of indicating the major items requiring further

investigation.

Professional controversy about the relation between inflation and unem-

ployment has been intertwined with controversy about the relative role of

monetary, fiscal, and other factors in influencing aggregate demand. One issue

deals with how a change in aggregate nominal demand, however produced,

works itself out through changes in employment and price levels; the other,

with the factors accounting for the changes in aggregate nominal demand.

The two issues are closely related. The effects of a change in aggregate

nominal demand on employment and price levels may not be independent of

the source of the change, and conversely the effect of monetary, fiscal, or other

forces on aggregate nominal demand may depend on how employment and

price levels react. A full analysis will clearly have to treat the two issues jointly.

Yet there is a considerable measure of independence between them. To a

first approximation, the effects on employment and price levels may depend

only on the magnitude of the change in aggregate nominal demand, not on its

source. On both issues, professional opinion today is very different than it was

just after World War II because experience contradicted tentatively accepted

hypotheses. Either issue could therefore serve to illustrate my main thesis.

I have chosen to deal with only one in order to keep this lecture within

reasonable bounds. I have chosen to make that one the relation between infla-

tion and unemployment, because recent experience leaves me less satisfied

with the adequacy of my earlier work on that issue than with the adequacy

of my earlier work on the forces producing changes in aggregate nominal

demand.

2. STAGE 1: NEGATIVELY SLOPING PHILLIPS CURVE

Professional analysis of the relation between inflation and unemployment has

gone through two stages since the end of World War II and is now entering a

third. The first stage was the acceptance of a hypothesis associated with the

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270

Economic Sciences 1976

name of A. W. Phillips that there is a stable negative relation between the

level of unemployment and the rate of change of wages - high levels of un-

employment being accompanied by falling wages, low levels of unemployment

by rising wages (24). The wage change in turn was linked to price change by

allowing for the secular increase in productivity and treating the excess of

price over wage cost as given by a roughly constant mark-up factor.

Figure 1 illustrates this hypothesis, where I have followed the standard

practice of relating unemployment directly to price change, short-circuiting

the intermediate step through wages.

This relation was widely interpreted as a causal relation that offered a

stable trade-off to policy makers. They could choose a low unemployment

target, such as U

L

. In that case they would have to accept an inflation rate of A.

There would remain the problem of choosing the measures (monetary, fiscal,

perhaps other) that would produce the level of aggregate nominal demand

required to achieve U

L

, but if that were done, there need be no concern about

maintaining that combination of unemployment and inflation. Alternatively,

the policy makers could choose a low inflation rate or even deflation as their

target. In that case they would have to reconcile themselves to higher unem-

ployment: U

o 

for zero inflation, U

H 

for deflation.

Economists then busied themselves with trying to extract the relation

depicted in Figure 1 from evidence for different countries and periods, to

eliminate the effect of extraneous disturbances, to clarify the relation between

wage change and price change, and so on. In addition, they explored social

gains and losses from inflation on the one hand and unemployment on the

other, in order to facilitate the choice of the “right” trade-off.

Unfortunately for this hypothesis, additional evidence failed to conform

with it. Empirical estimates of the Phillips curve relation were unsatisfactory.

More important, the inflation rate that appeared to be consistent with a speci-

fied level of unemployment did not remain fixed: in the circumstances of the

post-World War II period, when governments everywhere were seeking to

promote “full employment”, it tended in any one country to rise over time

and to vary sharply among countries. Looked at the other way, rates of

inflation that had earlier been associated with low levels of unemployment were

experienced along with high levels of unemployment. The phenomenon of

simultaneous high inflation and high unemployment increasingly forced itself

on public and professional notice, receiving the unlovely label of “stagflation”.

Some of us were sceptical from the outset about the validity of a stable

Phillips curve, primarily on theoretical rather than empirical grounds [(2),

(3), (4)]. What mattered for employment, we argued, was not wages in dollars

or pounds or kronor but real wages - what the wages  would buy in goods and

services. Low unemployment would, indeed, mean pressure for a higher real

wage - but real wages could  be higher even if nominal wages were lower,

provided that prices were still lower. Similarly, high unemployment would,

indeed, mean pressure for a lower real wage - but real wages could be lower,

even if nominal wages were higher, provided prices were still higher.

There is no need to assume a stable Phillips curve in order to explain the

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