Question

Why did Milton Friedman argue that the Phillips curve did not represent a permanent trade-off between unemployment and inflation? In your answer, be sure to explain what Friedman meant by the "natural rate of unemployment."

Short answer

Milton Friedman argued that the Phillips Curve does not represent a permanent trade-off between unemployment and inflation because the inverse relationship only holds in the short-run. Over the long run, the economy adjusts and tends towards its natural rate of unemployment which is not affected by the rate of inflation. The natural rate of unemployment is the lowest level of unemployment that an economy can sustain over the long run, considering the existing real-world frictions.

Step-by-step solution

Understanding the Phillips Curve

Start by defining the Phillips Curve, which is an economic concept showing an inverse relationship between rates of unemployment and corresponding rates of inflation. This curve arises from a simple empirical observation made by A.W. Phillips that, in an economy, high unemployment rates tends to be associated with low inflation, and vice versa.

Milton Friedman's critique of the Phillips Curve

Friedman argued against the concept of a long-run tradeoff between inflation and unemployment as depicted by the Phillips Curve. He explained that this inverse relationship could only hold in the short-run because in the long run, economic forces will adjust leading the economy towards its natural rate of unemployment, regardless of the inflation rate.

Understanding Natural Rate of Unemployment

Friedman’s interpretation of the 'Natural Rate of Unemployment' is the level of unemployment that the economy tends towards, over the long run, given the existing real-world frictions like imperfect information, minimum wages, etc. Once the economy is at this rate of unemployment, inflation does not have any effect on unemployment.

Key concepts

Milton Friedman

Milton Friedman was a pivotal figure in economics, well-known for his strong beliefs in free-market capitalism. His influence extended to a variety of economic concepts, most notably his critique of the then-popular Phillips Curve.

He challenged the notion that there was a stable, long-term trade-off between inflation and unemployment, which had significant policy implications. Instead, Friedman suggested that in the long run, such a trade-off does not exist and that attempts to manipulate the economy based on this assumption would lead to undesirable outcomes like persistent inflation without improvements in unemployment. His ideas were part of what later became known as monetarism, focusing on the role of governments in controlling the amount of money in circulation.

Natural Rate of Unemployment

The natural rate of unemployment is a concept central to Friedman’s economic theories. This term refers to the level of unemployment consistent with a stable rate of inflation, where the labor market is in equilibrium.

It encompasses the frictional and structural unemployment that exists even when the economy is at full capacity. These are the types of unemployment that arise from normal labor market turnover, such as workers transitioning between jobs or changes in the economy that make certain skills or industries obsolete.

Implications in Policy

According to Friedman, attempts to reduce unemployment below this natural rate through expansive monetary policy will only result in accelerating inflation.

Inflation and Unemployment Relationship

The relationship between inflation and unemployment has been a topic of significant debate among economists. The Phillips Curve initially suggested an inverse relationship: as unemployment decreases, inflation increases, and vice versa.

However, this relationship is much more complex. Friedman highlighted that this inverse relationship only holds in the short-term because individuals and businesses adjust their expectations of inflation over time.

Inflation Expectations

When people start to anticipate higher inflation, they adjust their behavior in ways that nullify the intended effects of monetary policy on unemployment. This leads to a scenario where inflation and unemployment can rise simultaneously, like in the stagflation of the 1970s.

Short-run vs Long-run Economics

The distinction between short-run and long-run economics is crucial for understanding the Phillips Curve and Friedman’s critique of it.

In the short run, certain economic policies can influence unemployment and inflation. Policymakers, for example, might attempt to decrease unemployment by increasing the money supply, which can reduce interest rates and boost demand for goods and services. Initially, this can lower unemployment but eventually, as Friedman argued, inflation expectations adjust and these effects are negated.

The long run is a conceptual period in which all markets have adjusted to any changes, and all economic variables are at their natural levels, including the natural rate of unemployment. Thus, long-run policy should focus on sustainable economic growth rather than attempting to exploit a short-term trade-off between inflation and unemployment.