Milton Friedman Prize Lecture
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282 Economic Sciences 1976 factors that seem likely to raise unemployment, not high volatility or a high level of intervention. Ways of coping with both volatility and intervention will develop: through indexing and similar arrangements for coping with volatility of inflation; through the development of indirect ways of altering prices and wages for avoiding government controls. Under these circumstances, the long-run Phillips curve would again be vertical, and we would be back at the natural-rate hypothesis, though perhaps for a different range of inflation rates than that for which it was first suggested. Because the phenomenon to be explained is the coexistence of high inflation and high unemployment, I have stressed the effect of institutional changes pro- duced by a transition from a monetary system in which there was a “normal” price level to a monetary system consistent with long periods of high, and possibly highly variable, inflation. It should be noted that once these institu- tional changes were made, and economic agents had adjusted their practices and anticipations to them, a reversal to the earlier monetary framework or even the adoption in the new monetary framework of a successful policy of low inflation would in its turn require new adjustments, and these might have many of the same adverse transitional effects on the level of employment. There would appear to be an intermediate-run negatively sloped Phillips curve instead of the positively sloped one I have tried to rationalize. 5. CONCLUSION One consequence of the Keynesian revolution of the 1930’s was the acceptance of a rigid absolute wage level, and a nearly rigid absolute price level, as a starting point for analyzing short-term economic change. It came to be taken for granted that these were essentially institutional data and were so regarded by economic agents, so that changes in aggregate nominal demand would be reflected almost entirely in output and hardly at all in prices. The age-old confusion between absolute prices and relative prices gained a new lease on life. In this intellectual atmosphere it was understandable that economists would analyze the relation between unemployment and nominal rather than real wages and would implicitly regard changes in anticipated nominal wages as
equal to changes in anticipated real wages. Moreover, the empirical evidence that initially suggested a stable relation between the level of unemployment and the rate of change of nominal wages was drawn from a period when, despite sharp short-period fluctuations in prices, there was a relatively stable long-run price level and when the expectation of continued stability was widely shared. Hence these data flashed no warning signals about the special character of the assumptions. The hypothesis that there is a stable relation between the level of unem- ployment and the rate of inflation was adopted by the economics profession with alacrity. It filled a gap in Keynes’ theoretical structure. It seemed to be the “one equation” that Keynes himself had said “we are . . . short” (15). In
M. Friedman 283 addition, it seemed to provide a reliable tool for economic policy, enabling the economist to inform the policy maker about the alternatives available to him. As in any science, so long as experience seemed to be consistent with the reigning hypothesis, it continued to be accepted, although as always, a few dissenters questioned its validity. But as the ‘50’s turned into the ‘60’s, and the ‘60’s into the ‘70’s, it became increasingly difficult to accept the hypothesis in its simple form. It seemed to take larger and larger doses of inflation to keep down the level of unemploy- ment. Stagflation reared its ugly head. Many attempts were made to patch up the hypothesis by allowing for special factors such as the strength of trade unions. But experience stubbornly refused to conform to the patched up version. A more radical revision was required. It took the form of stressing the importance of surprises - of differences between actual and anticipated magni- tudes. It restored the primacy of the distinction between “real” and “nominal” magnitudes. There is a “natural rate of unemployment” at any time deter- mined by real factors. This natural rate will tend to be attained when expecta- tions are on the average realized. The same real situation is consistent with any absolute level of prices or of price change, provided allowance is made for the effect of price change on the real cost of holding money balances. In this re- spect, money is neutral. On the other hand, unanticipated changes in aggregate nominal demand and in inflation will cause systematic errors of perception on the part of employers and employees alike that will initially lead unemploy- ment to deviate in the opposite direction from its natural rate. In this respect, money is not neutral. However, such deviations are transitory, though it may take a long chronological time before they are reversed and finally eliminated as anticipations adjust. The natural-rate hypothesis contains the original Phillips curve hypothesis as a special case and rationalizes a far broader range of experience, in particular the phenomenon of stagflation. It has by now been widely though not univer- sally accepted. However, the natural-rate hypothesis in its present form has not proved rich enough to explain a more recent development - a move from stagflation to slumpflation. In recent years, higher inflation has often been accompanied by higher unemployment - not lower unemployment, as the simple Phillips curve would suggest, nor the same unemployment, as the natural-rate hypo- thesis would suggest. This recent association of higher inflation with higher unemployment may reflect the common impact of such events as the oil crisis, or independent forces that have imparted a common upward trend to inflation and unemployment. However, a major factor in some countries and a contributing factor in others may be that they are in a transitional period - this time to be measured by quinquennia or decades not years. The public has not adapted its attitudes or its institutions to a new monetary environment. Inflation tends not only to be higher but also increasingly volatile and to be accompanied by widening government intervention into the setting of prices. The growing volatility of
284 Economic Sciences 1976 inflation and the growing departure of relative prices from the values that market forces alone would set combine to render the economic system less efficient, to introduce frictions in all markets, and, very likely, to raise the recorded rate of unemployment. On this analysis, the present situation cannot last. It will either degenerate into hyperinflation and radical change; or institutions will adjust to a situation of chronic inflation; or governments will adopt policies that will produce a low rate of inflation and less government intervention into the fixing of prices. I have told a perfectly standard story of how scientific theories are revised. Yet it is a story that has far-reaching importance. Government policy about inflation and unemployment has been at the center of political controversy. Ideological war has raged over these matters. Yet the drastic change that has occurred in economic theory has not been a result of ideological warfare. It has not resulted from divergent political beliefs or aims It has responded almost entirely to the force of events: brute experience proved far more potent than the strongest of political or ideological preferences. The importance for humanity of a correct understanding of positive economic science is vividly brought out by a statement made nearly two hundred years ago by Pierre S. du Pont, a Deputy from Nemours to the French National Assembly, speaking, appropriately enough, on a proposal to issue additional assignats - the fiat money of the French Revolution: “Gentlemen, it is a disagreeable custom to which one is too easily led by the harshness of the discussions, to assume evil intentions. It is necessary to be gracious as to intentions; one should believe them good, and apparently they are; but we do not have to be gracious at all to inconsistent logic or to absurd reasoning. Bad logicians have committed more involuntary crimes than bad men have done intentionally” (25 September 1790). ACKNOWLEDGMENTS I am much indebted for helpful comments on the first draft of this paper to Gary Becker, Karl Brunner, Phillip Cagan, Robert Gordon, Arnold Harberger, Harry G. Johnson, S. Y. Lee, James Lothian, Robert E. Lucas, David Meisel- man, Allan Meltzer, Jose Scheinkman, Theodore W. Schultz, Anna J. Schwartz, Larry Sjaastad, George J. Stigler, Sven-Ivan Sundqvist, and participants in the Money and Banking Workshop of the University of Chicago. I am deeply indebted also to my wife, Rose Director Friedman, who took part in every stage of the preparation of the paper, and to my secretarial assistant, Gloria Valentine, for performance above and beyond the call of duty. M. Friedman 285 REFERENCES (1) (2)
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