Tag Archives: Milton Friedman

A2 Economics – Wage Price Spiral and the Long Run Phillips Curve

Phillips CurvePart of the CIE A2 macro syllabus focuses on the wage price spiral which relates to the Phillips Curve. Here are some excellent notes that I picked up from Russell Tillson in my early days teaching at Epsom College. As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve.

During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

Are Markets Free?

Smith FriedmanMilton Friedman in his book “Capitalism and Freedom” suggests that the central problem of economics is how to ensure the cooperation of free individuals without compulsion. Scottish economist Adam Smith saw that, in the absence of external coercion, two parties enter into exchanges because it will be mutually beneficial for them to do so provided the transaction is bi-laterally voluntarily and informed. No exchange will take place unless both parties benefit. This seems to be the conventional definition of the free-market economy.

However the market is not as free as one would think and the power of the business strategy prevails. Marketing is a significant cost for most businesses but the majority of contemporary marketing is based not on providing information but on associating products with evocative images and themes not directly related to the product itself. Goods that cannot be ‘commodified’, such as self-esteem, love, friendship and success, for example, are associated with products that bear little or no relationship to those goods.

Marketers intensify the desire for such goods by calling into question the acceptability of the consumer, which General Motors’ research division once called “the organised creation of dissatisfaction”.

Another concentration of power is in the enormous transnational corporations through mergers and acquisitions. Over the last two decades there has been a significant rise in mergers and acquisitions as large corporations seek to outdo their rivals through the increase in size that ultimately leads to economies of scale and market power. For instance the meat packaging industry in the United States is dominated by four companies that handle the 80% of beef production that leaves small farmers with limited power in the pricing of their cattle. Independent bookshops and department stores worldwide have struggled with the size of the competition in the market and the onset of the online medium. Consumers have preferred the bigger firms as they are more efficient and can provide the product at a cheaper price. However paradoxically the consumer has used his/her freedom to restrict their freedom, since now there are fewer choices available, and they are increasingly faced with the prospect of frequenting the same few chains stores whether they like it or not.

A much more publicised view of asymmetrical power is the exchange between employer and employee. Executive pay in the last two decades has increased dramatically – in 1980 the average CEO earned 42 times that of the average worker but by 1999 it had reached 475:1 and today approximately 600:1. Union membership has declined considerably since the 1980s when is it was well over 20%. In 2012 only 11.1% of workers were members of unions.

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The above is a brief extract from an article published in this month’s econoMAX – click below to subscribe to econoMAX the online magazine of Tutor2u. Each month there are 8 articles of around 600 words on current economic issues.

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