The Textbook Rendition of the Short-Run Phillips Curve Dynamics Clashes with the Empirical Record and with a Fundamental Proposition of Monetarism

Textbook writers and even many self-identified monetarists have taken this short-run/long-run Phillips curve analysis to be the monetarists’ account of the market mechanisms that cause a money-induced boom to go bust. Much more plausibly, however, Friedman’s presidential address was intended only as immanent criticism of the views held by his Keynesian-oriented contemporaries. Many saw the Keynes-inspired downward-sloping Phillips curve as an enduring trade-off between inflation and unemployment, a virtual menu of policy choice for left-leaning politicians willing to put up with inflation in order to reduce unemployment and for right-leaning politicians willing to put up with unemployment in order to reduce inflation. Friedman’s message was simply that there is no long-run trade-off. 

The common textbook rendition of the short-run Phillips curve dynamics actually clashes both with the empirical record and with a fundamental proposition of monetarism. The low unemployment rate during the boom depends on wage rates lagging behind rising output prices. This sequence would mean that real wage rates are relatively low during the boom. But the notion of low real wages during credit-induced booms has no empirical support. (In the Austrian view, the artificially cheap credit increases investment, increases the demand for labor, and hence increases the real wage rate. In fact, the higher real wages are in large part responsible for the political popularity of credit-induced booms). 

Not long after Friedman offered his criticism of the Phillips curve as a menu of choice, he set out ten fundamental propositions of monetarism, which included the proposition that a monetary expansion causes quantities (output and, as a virtual prerequisite, employment) to increase first and prices only later. With this sequence, of course, it cannot be the rising prices that, being differentially perceived by employers and employees, are responsible for increased employment and output. Friedman actually finessed the issue of “quantities then prices” versus “prices then quantities” in his presidential address, portraying the latter as an extra boost during a later phase of the adjustment process. But it was exclusively the “prices then quantities” sequence that became the standard textbook version, formalized by Robert E. Lucas Jr. as a monetary misperception theory of the business cycle. In any case, the “quantities then prices” understanding, which Friedman favored, is evidently not strong enough to show up in his highly aggregative monetarist framework as an empirically verifiable boom-bust sequence.

—Roger W. Garrison, review of Alchemists of Loss: How Modern Finance and Government Regulation Crashed the Financial System, by Kevin Dowd and Martin Hutchinson, The Independent Review: A Journal of Political Economy 16, no. 3 (Winter 2011/2012): 444-445.