The development of monetary policy – Part 2

Phillips curve critique

The 1970s stagflation crisis has since been illustrated as a fatal blow to the Phillips curve. The Phillips curve could no longer guarantee a perfectly inverse relation between unemployment and inflation, and thus, the impotence of monetary policy. The major critique of the Phillips curve was by economists Milton Friedman and Edmund Phelps. Friedman and Phelps argued that the Phillips curve was only true in the short term, and that in the long term, unemployment would revert back to a ‘natural rate’.[1] They illustrated this by explaining the effects of a central bank targeting an unemployment rate below the natural rate. Initially, the central bank would implement low interest rates to stimulate the economy. The increased availability of money would increase demand, and thus, holding supply the same would lead to an increase in prices.[2] Firms would attempt to reap the rewards of increased demand by expanding and hence, need to hire more staff. Initially, staff would be hired at the rate of current employers, or, the nominal rate. However, due to inflation, employees are actually getting paid less in real terms. Friedman and Phelps termed this phenomenon, ‘money illusion’.[3] As employees realise their wages are actually worth less in real terms, they expect a raise. As firms are forced to pay their workers more they layoff workers, hence returning unemployment to the ‘natural level’. However, this does not tame inflation as the low interest rates are still artificially increasing demand and thus, pushing prices above market value. This would set off a price-wage spiral.[4]

Friedman summarised his critique of the Phillips curve by saying that it fails to distinguish between nominal and real wages. The Phillips curve would work in the short term, because employees were being paid less in real terms. However, in the long term, as employees became aware of this, they would fight for their wage to be increased, resulting in a return to a natural rate of unemployment, but inflation would still be driven up by the low interest rates. Indeed, this scenario played out in the 1970s stagflation crisis. Low interest rates, precipitated by price controls in the US preceded a vast increase in the price of oil, which filtered excess demand to overseas oil producers. From 1960 to 1970, inflation had gone from 2.5% to 7%, while unemployment had increased from 4% to 6%.[5] However, the oil crisis was just a ramification of the overarching macroeconomic failures of the Nixon administration. By 1982, the oil industry had become more competitive, with less than 50% supplied by OPEC nations, with the US itself expanding its oil industry. However, US inflation was still high. It was in 1978, the year in which Federal Reserve Chairman, Paul Volcker, instigated contractionary interest rates, that commodity prices began to deflate.

The Friedman/Phelps legacy

Friedman and Phelps’ critique of the Phillips curve resulted in economists’ conceiving of a ‘natural rate of unemployment’.[3] In the world of economics, this was referred to as the non-accelerated inflation rate of unemployment (NAIRU). The NAIRU is the level of unemployment, below which inflation rises. The NAIRU was used to advance the idea that central banks should keep interest rates at a steady rate. Friedman believed this rate should be in line with real GDP, which he estimated would be at 2-3%.[6] This is known as the ‘k percent rule’, as it advocates a steady percentage increase in the rate of inflation.[3] This is the main tenet of Friedman’s theory for monetary policy, known as monetarism. Monetarism professes that a constant percentage increase in the rate of inflation will result in monetary stability, inevitably fostering economic stability. Friedman’s theory was groundbreaking, as it overturned the monetary belief advanced by Keynesians, which believed that monetary policy had no influence over the stability of the economy. Friedman challenged the Keynesian belief that the central bank could simply make a trade-off between unemployment and inflation to their liking, by professing a natural rate that the economy would always fall back on in the long run. The main point of dispute over Friedman’s theory, is over where the NAIRU sits.


However, the NAIRU remains an ill-defined economic concept,  due to the lack of empirical evidence surrounding it.[7] Even Milton Friedman admitted that we ‘cannot know what the “natural” rate is’.[3] Consequently, key questions on it remain unanswered, such as: where the rate is, how it can be influenced and what factors led to it in the first place. Thus, the NAIRU is a useful tool to capture the way an economy behaves outside equilibrium, however, cannot yet be used to project a vision for monetary policy.

The spectre of stagflation

So, when the RBA is talking about decreasing interest rates, they are trying to stimulate the economy through increasing the flow of money in the economy. However, they need to be cautious in cutting rates, as pushing unemployment beneath the ‘natural’ rate, could result in ever increasing inflation. Currently, the RBA is discussing whether to cut the cash rate to stimulate the economy, with growing fears of a looming recession.[8] Headlining the stagnation in the Australian economy are stagnant wages. Interestingly, this trend has been partly caused by underemployment, rather than unemployment, with much of the modern work being a part of the ‘gig economy’.[9] This complicates calculations as underemployed workers do not have the income necessary to stimulate the economy as those that used to be considered ‘employed’ would.[11] Thus, a recession may be inevitable. Holistically, this offers an obfuscated picture to the central banks of today. Much of the monetary theories have shown an inability to grasp the relation between unemployment and growth and how it can be translated into continued growth and a stable currency.

[1] Hoover, K. D. (2008). Phillips curve. The concise encyclopedia of economics.

[2] This is known as demand pull inflation

[3] Friedman, M. (1995). The role of monetary policy. In Essential Readings in Economics (pp. 215-231): Springer.

[4] Dehejia, V. (2018). How Milton Friedman and Edmund Phelps changed macroeconomics. Retrieved from

[5] Barsky, R., & Kilian, L. (2000). A Monetary Explanation of the Great Stagflation of the 1970s.

[6] Dobrescu, M., Paicu, C., & Iacob, S. (2011). The Natural Rate of Unemployment and its Implications for Economic Policy. Theoretical & Applied Economics, 18(2).

[7] Chang, R. (1997). Is low unemployment inflationary? Economic Review (Atlanta, Ga.), 82(1), 4-14.

[8] Letts, S. (2019). Record low inflation reading puts pressure on the Reserve Bank to cut interest rates. ABC. Retrieved from

[9] Chua, C. L., & Robinson, T. (2018). Why Has Australian Wages Growth Been So Low? A Phillips Curve Perspective. Economic Record, 94, 11-32.

[10] Bishop, J., & Cassidy, N. (2017). Insights into low wage growth in Australia. RBA Bulletin, March, 13-20.

[11] Walters, S. (2016). The next recession we have to have Spring 2016. Retrieved from