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Donald Boudreaux: 1968 a milestone year for economics, too

This has been a banner year for historical reflection — in particular, reflection on 1968. That year of exactly a half-century ago witnessed much more than its share of historically significant tragedies and achievements. Assassinations and extraordinary political turmoil here at home, the Tet offensive and the My Lai massacre in Vietnam, and (more inspiringly) Apollo 8 orbiting the moon — these and other unusually important events do indeed make 1968 a year especially worthy of reflection.

1968 is especially noteworthy also for an economic event: the publication of Milton Friedman’s article “The Role of Monetary Policy.” In this, his presidential address to the American Economic Association, Friedman (1912-2006) buried the then-widely accepted myth that society faces an unavoidable tradeoff between employment and inflation.

For much of the post-World War II period until 1968, economists and policymakers had come to believe that two desirable economic outcomes — full employment and low inflation — are incompatible with each other. As an economy moved closer to full employment, the conventional wisdom insisted, it must pay the price of higher inflation. And if the people of that economy want to reduce inflation, they can do so, but only if they’re willing to suffer increased unemployment. “Tradeoffs,” economists stoically lamented, “are unavoidable.”

Enter Friedman with happy news: There is no long-run tradeoff between employment and price stability. We can have full employment and low inflation. No need to choose.

Why, though, did so many intelligent people ever believe the contrary? The answer, according to Friedman, is that they mistakenly assumed that what is true in the short run is also necessarily true in the long run. In the short run a central bank can indeed raise the level of employment by increasing the supply of money — that is, by fueling inflation.

Because increases in the money supply typically cause output prices to rise before causing wages to rise, the initial rise in output prices makes it profitable for firms to hire more workers in order to increase outputs. But the inflation eventually causes nominal wages also to rise — which prompts firms to restore their previous levels of employment and output. So what appears in the short run to be a connection between inflation and employment turns out in the long run to be no such thing.

Friedman went further. He noted that people are neither stupid nor short-sighted. We form expectations about future inflation based upon our experience. If, say, inflation has been running at a 6-percent annual clip, then employers and workers — and borrowers and lenders — all eventually incorporate an expected 6-percent annual rate of inflation into their plans going forward. And so when employers actually witness the prices of the goods they sell rising by 6 percent, they’ll know that a similar rise in wages isn’t far behind. This inflation no longer causes employers to hire more workers.

And so, argued Friedman, the only way a central bank can artificially stimulate employment is for it to bring about inflation that is unexpectedly high — say, causing inflation to be ten percent when people expect only a six-percent rate. But Friedman insisted that this game is for fools. It leads to constantly accelerating inflation with no long-run effect on employment.

Friedman counseled that central banks should therefore follow a strict rule of keeping inflation low.

Donald Boudreaux is a professor of economics and Getchell Chair at George Mason University in Fairfax, Va. His column appears twice monthly.


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