Milton Friedman Prize Lecture

280

Economic Sciences 1976

direction to the other, encouraging wide variation in the actual and anti-

cipated rate of inflation. And, of course, in such an environment, no one has

single-valued anticipations. Everyone recognizes that there is great uncertainty

about what actual inflation will turn out to be over any specific future interval

[Jaffe and Kleiman (14); Meiselman (20)].

The tendency for inflation that is high on the average to be highly variable

is reinforced by the effect of inflation on the political cohesiveness of a country

in which institutional arrangements and financial contracts have been adjusted

to a long-term “normal” price level. Some groups gain (e.g., home owners);

others lose (e.g., owners of savings accounts and fixed interest securities),

“Prudent” behavior becomes in fact reckless, and “reckless” behavior in fact

prudent. The society is polarized; one group is set against another. Political

unrest increases. The capacity of any government to govern is reduced at the

same time that the pressure for strong action grows.

An increased variability of actual or anticipated inflation may raise the

natural rate of unemployment in two rather different ways.

First, increased volatility shortens the optimum length of unindexed com-

mitments and renders indexing more advantageous [Gray (10)]. But it takes

time for actual practice to adjust. In the meantime, prior arrangements intro-

duce rigidities that reduce the effectiveness of markets. An additional element

of uncertainty is, as it were, added to every market arrangement. In addition,

indexing is, even at best, an imperfect substitute for stability of the inflation

rate. Price indexes are imperfect; they are available only with a lag, and

generally are applied to contract terms only with a further lag.

These developments clearly lower economic efficiency. It is less clear what

their effect is on recorded unemployment. High average inventories of all

kinds is one way to meet increased rigidity and uncertainty. But that may

mean labor-hoarding by enterprises and low unemployment or a larger force

of workers between jobs and so high unemployment. Shorter commitments may

mean more rapid adjustment of employment to changed conditions and so low

unemployment, or the delay in adjusting the length of commitments may lead

to less satisfactory adjustment and so high unemployment. Clearly, much

additional research is necessary in this area to clarify the relative importance

of the various effects. About all one can say now is that the slow adjustment of

commitments and the imperfections of indexing may contribute to the recorded

increase in unemployment.

A second related effect of increased volatility of inflation is to render market

prices a less efficient system for coordinating economic activity. A fundamental

function of a price system, as Hayek (13) emphasized so brilliantly, is to trans-

mit compactly, efficiently, and at low cost the information that economic

agents need in order to decide what to produce and how to produce it, or how

to employ owned resources. The relevant information is about 

relative 

prices -

of one product relative to another, of the services of one factor of production

relative to another, of products relative to factor services, of prices now

relative to prices in the future. But the information in practice is transmitted

in the form of absolute prices - prices in dollars or  pounds or kronor. If the

---

M. Friedman

281

price level is on the average stable or changing at a steady rate, it is relatively

easy to extract the signal about relative prices from the observed absolute

prices. The more volatile the rate of general inflation, the harder it becomes to

extract the signal about relative prices from the absolute prices: the broadcast

about relative prices is as it were being jammed by the noise coming from the

inflation broadcast [Lucas (18), (19); Harberger (11)]. At the extreme, the

system of absolute prices becomes nearly useless, and economic agents resort

either to an alternative currency, or to barter, with disastrous effects on

productivity.

Again, the effect on economic efficiency is clear, on unemployment less so.

But, again, it seems plausible that the average level of unemployment would

be raised by the increased amount of noise in market signals, at least during the

period when institutional arrangements are not yet adapted to the new situation.

These effects of increased volatility of inflation would occur even if prices

were legally free to adjust - if, in that sense,  the inflation were open. In practice,

the distorting effects of uncertainty, rigidity of voluntary long-term contracts,

and the contamination of price signals will almost certainly be reinforced by

legal restrictions on price change. In the modern world, governments are

themselves producers of services sold on the market: from postal services to a

wide range of other items. Other prices are regulated by government, and

require government approval for change:

 

from air fares to taxicab fares to

charges for electricity. In these cases, governments cannot avoid being involved

in the price-fixing process, In addition, the social and political forces unleashed

by volatile inflation rates will lead governments to try to repress inflation in

still other areas: by explicit price and wage control, or by pressuring private

businesses or unions “voluntarily” to exercise “restraint”, or by speculating

in foreign exchange in order to alter the exchange rate.

The details will vary from time to time and from country to country, but

the general result is the same: reduction in the capacity of the price system

to guide economic activity; distortions in relative prices because of the intro-

duction of greater friction, as it were, in all markets; and, very likely, a higher

recorded rate of unemployment [(5)].

The forces I have just described may render the political and economic

system dynamically unstable and produce hyperinflation and radical political

change - as in many defeated  countries after World War I, or in Chile and

Argentina more recently. At the other extreme, before any such catastrophe

occurs, policies may be adopted that will achieve a relatively low and stable

rate of inflation and lead to the dismantling of many of the interferences with

the price system. That would re-establish the preconditions for the straight-

forward natural-rate hypothesis and enable that hypothesis to be used to pre-

dict the course of the transition.

An intermediate possibility is that the system will reach stability at a fairly

constant though high average rate of inflation. In that case, unemployment

should also settle down to a fairly constant level decidedly lower than during

the transition. As the preceding discussion emphasizes, 

increasing 

volatility

and 

increasing 

government intervention with the price system are the major

---