It is a well-known belief that by means of monetary policy, the central bank can influence the rate of real economic expansion. It is also held that this influence, however, carries a price, which manifests itself in terms of inflation.

For instance, if the goal is to reach a faster economic growth rate and a lower unemployment rate then citizens should be ready to pay a price for this in terms of a higher rate of inflation.

It is held that there is a trade-off between inflation and unemployment, which is depicted by the Phillips curve. (William Phillips described a historical relationship between the rates of unemployment and the corresponding rates of rises in wages in the United Kingdom,1861-1957, published in the quarterly journal of Economica,1958).

The inverse correlation between the rate of inflation and the unemployment rate has become an important element in the theory of price inflation. The lower the unemployment rate the higher the inflation rate. Conversely, the higher the unemployment rate the lower the inflation rate is going to be.

The events of the 1970’s came as a shock for most economists. Their theories based on the supposed existing trade-off suddenly became useless. During the 1974-75 period, a situation emerged where the growth momentum of prices strengthened while at the same time the pace of real economic activity had been declining. This unexpected event was labeled as stagflation.

In March 1975, US industrial production fell by nearly 13% while the yearly growth rate of the consumer price index (CPI) jumped to around 12%.

Likewise, a large fall in economic activity and galloping price inflation was observed during 1979. By December of that year, the yearly growth rate of industrial production stood close to nil while the growth rate of the CPI stood at over 13%.

Again the stagflation of 1970’s was a big surprise to most mainstream economists who held that a fall in real economic growth and a rise in the unemployment rate should be accompanied by a fall in the inflation rate and not an increase.

Some economists such as Milton Friedman and Edmund Phelps were questioning the popular view arguing that there cannot be a trade-off between economic growth and inflation in the long-term. They were suggesting that this could only occur in the short term. Based on this way of thinking they have formulated the stagflation theory.

The Friedman-Phelps (FP) Explanation of Stagflation

Starting from a situation of equality between the current and the expected inflation rate the central bank decides to lift the rate of economic growth by lifting the growth rate of money supply.

As a result, a greater supply of money enters the economy and each individual now has more money at his disposal. Because of this increase, every individual is of the view that he has become wealthier.

This raises the demand for goods and services, which in turn sets in motion an increase in the production of goods and services. All this, in turn, lifts producers demand workers and consequently the unemployment rate falls to below the equilibrium rate, which both Friedman and Phelps labeled as the natural rate.1