What are the Demerits of Friedman-Phelps Model of Stagflation?

Friedman-Phelps model of stagflation has been criticised on the following grounds:

1. Persistence of Unemployment:

Friedman-Phelps model fails to provide proper explanation for the persistence of unemployment at levels either above or below the equilibrium or natural rate.

According to this model, unemployment persistence is caused by delays in the flow of information generated endogenously in the model by the inflationary or deflationary surprises.

But, unfortunately, the delay is not generated endogeneously by the model and its length is a matter of judgment. Thus, it is difficult to test how much of the observed variance in unemployment can be attributed to inflationary or deflationary surprises.

2. Degree of Adjustment to Inflation:

Friedman-Phelps model depends crucially on a specific assumption regarding the degree of adjustment of expected inflation to actual inflation (or the value of α in the model). There are three possibilities:

(i) a in the model can take the value unity, which implies that expected inflation is fully incorporated into current wage changes, so that there is absence of money illusion; there is no trade-off between inflation and unemployment in the long run and the Phillips curve is vertical.

(ii) If, on the other extreme, a takes the value zero, then Phillips’ original formulation is correct which means that there is only one negatively sloping Phillips curve regardless of price expectations; inflation-unemployment trade-off exists and workers have money illusion.

(iii) In between these two extreme cases is the situation in which 0< ∞ < 1, which means that there is partial but not complete compensation for anticipated inflation.

This case implies that there is a long-rim Phillips curve which, although more steeply sloped than the short-run ones, is not vertical; there is some trade-off between inflation and unemployment, and workers have money illusion even in the long-run.

Friedman-Phelps model, with its prediction that there is no inflation-unemployment trade-off in the long-run, is based on the assumption of α = 1 (i.e., first possibility) and ignores the other possibilities (i.e., second and third).

3. Empirical Evidence:

What is the actual value of α in the actual world is an empirical question. Majority of the research studies have shown that α falls in the range between .3 to .8, implying the existence of a negatively sloping long-run Phillips curve.

Such findings suggest that, while people are rational and do adjust to inflation, they are subject to some degree of money illusion and do not therefore fully adjust to inflation.

4. Implication about Money Illusion:

Even if the degree of adjustment to inflation (value of α) is significantly less than unity or nearly zero, this need not necessarily imply the presence of money illusion.

In case where the wage is determined by collective bargaining, the workers may, for some reason, be prevented from fully incorporating their inflationary expectations into money wage settlements.

For example, Rees argued that the transactions costs involved in continuously adjusting the real wage under inflationary condi­tions may be sufficiently high to discourage complete adjustment for expected inflation.

5. Formation of Expectations Criticised:

Friedman-Phelps model assumes that expectations are generated according to the adaptive expectations mechanism which implies that current expectations are equal to the weighted average of past rates of inflation.

This assumption has been challenged by the recent development of the concept of rational expectations, according to which expectations are formed rationally on the basis of an economic model of the determination of the variable in question, rather than on the basis of weighted average of past values of the variable.

6. Rational Expectations Hypothesis:

Friedman-Phelps, model maintains that monetary policy can affect real variables like employment and output only in the short run, because people can be fooled only in the short run, and not in the long run.

According to the rational expec­tations hypothesis, the stabilisation policies cannot systematically fool people.

For example, monetary policy cannot lead people to wrongly estimate the rate of inflation; some will underestimate and others will overestimate. This implies that the stabilisation policy cannot systematically influence employment and output even in the short run.

7. Vague Concept of Natural Rate of Unemployment.

The concept of natural rate of unemployment on which the Friedman-Phelps model is based has been criticised on the ground that it is a vague concept. It has not been defined in specific terms.