Practice question · Multiple choice
Stagflation, high inflation with high unemployment, was supposed to be impossible under the Phillips curve. What did the 1970s reveal about the relationship?
Hints
- Ask what workers do when they come to expect 8% inflation every year.
- Friedman predicted the breakdown in 1968, before it happened. What was he reasoning about?
Show the answer
C. That the trade-off depends on expectations, which adjust
Why
A trade-off that depends on fooling people stops working once they stop being fooled, so the curve shifts up with expectations and the policy has to keep escalating. Friedman and Phelps predicted this before it occurred, one of macroeconomics' genuine out-of-sample successes, and it is why central banks now target expectations directly.
Practise Oil Shocks and Stagflation
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