Inflation-Unemployment Trade-off under Adaptive Expectations:
By the late 1960s, the inverse relation between inflation and unemployment as suggested by the Phillips curve was increasingly questioned, especially in the United States. "It was because prevailing rates of unemployment seemed to be associated with rates of inflation much higher than would be expected on the basis of Phillips curves estimated from the past. There was economic stagnation depicted through negligible GDP growth on the one hand and high rate of inflation on the other, a situation termed in economic jargon as "stagflation". In his presidential address to the American Economic Association in 1968, Milton Friedrnan advanced an argument as to why the Phillips curve might not represent a stable exploitable trade-off for policy making. Subsequently, this argument gained wide acceptance.
Friedrnan argued that workers, in making their labour supply decisions, were concern not with their money wage rates but with their real wage rates. Moreover, given the structural characteristics of an economy, there was a unique equilibrium rate of unemployment in the economy called the natural rate of unemployment. At this rate of unemployment, firms and employed workers would be satisfied with the real wage rate paid for work done and it would not be desirable, given the constraints the faced, for both firms and unemployed workers to establish an employment relationship at lower real wage rate'.
It might be due, for example, to the fact that because of the heterogeneous nature of Rational Expectations and jobs and the work force, some time is required by firms and workers to respectively Economic Theory find information about and search for appropriate workers and jobs. Or, it might be due to the fact that some unemployed workers due to costs of mobility (between geographical places or occupations) or due to other labour market imperfections (such as the actions of organised labour - trade unions) are not in a position to seek employment by lowering wages. Other possible causes will be discussed later when we consider theories of unemployment.
At rates of unemployment lower than the natural rate, firms, employing more labour, would want to pay a real wage lower than what they pay at the higher natural rate of unemployment, while a higher, real wage rate must prevail in order for workers to supply more labour. If workers and firms entered into an employment relationship in terms of a stipulated real wage rate, then a rate of unemployment lower than the natural rate would never prevail.
However, workers and firms actually enter into an employment relationship on the basis of a stipulated nominal or money wage rate. Now, suppose that at a particular time, workers when they make their decisions on whether to accept job offers at a particular money wage rate, expect a lower future price level than firms expect when they decide to make these offers. That is, workers expect a lower rate of price inflation in the economy than do firms. Then a rate of unemployment lower than the natural rate might prevail because the expected real wage rate for workers would be greater than the expected real wage rate for firms.