“Stagflation,” high unemployment combined with high inflation, undermined economists’ confidence in Keynesian economics. In the 1960s, economists had believed in a stable Phillips (1958) curve: Unemployment could be permanently lowered at the cost of permanently higher inflation (see Economic Insight 28.2). Now they realized that the Phillips curve represented only a temporary trade-off. Once workers and employers adjusted to a higher rate of inflation, unemployment would move back to its “natural” rate. This new view of the Phillips curve was developed by Edmund Phelps and Milton Friedman. They found that if prices would initially rose faster than wages, real wages would fall, stimulating employment. Once workers caught on, however, they would demand wage increases in line with price increases, and unemployment would return to its “natural” rate. Economists of all persuasions began to accept the new view of the Phillips curve, but liberal economists preferred the term non-accelerating inflation rate of unemployment (NAIRU) to natural rate because the former leaves open the question of whether it is a “good” rate. (This is also an example of the kind of humor that appeals to economists: The Nehru suit was fashionable at the time.) The policy implications were clear. Governments should not try to reduce unemployment to the lowest possible rate through expansionary monetary and fiscal policies because the benefit would lead to inflation and only temporarily reduce unemployment (remember Economic Reasoning Proposition 2, choices impose costs). Better would be a stable monetary and fiscal framework.
World History
