With the existence of stagflation, new economic models appeared during 1970s. M. Friedman and E.S. Phelps sought to explain the phenomenon of stagflation (or the instability of the Phillips curve) in terms of inflationary expectations; changes in inflationary expectations cause shifts in the Phillips curve.
According to the Friedman-Phelps model, the Phillips curve is wrongly specified because it is the real wage, and not money wage, that responds to the excess labour demand.
The Phillips curve trade-off between money wage inflation and unemployment can exist only temporarily so long as the buyers and sellers of labour are fooled, i.e., so long as they both confuse money wages with real wages and do not correctly anticipate the inflation rate.
In other words, changes in money wage rates can offset the rate of unemployment only in the short run because it is only in the short run that employers and labourers confuse money wage changes with real wage changes and thus wrongly interpret inflation.
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For example, as a result of an expansionary monetary policy, an economy experiences price and wage inflation. This increase in money wages will be incorrectly interpreted by the producers as a reduction in the real wages and by the labourers as an increase in real wages.
The short run effect will therefore be an increase in both employment and the rate of inflation. It appears that the Phillips curve prediction is true i.e., inflation has led to a reduction in unemployment.
But, this is only a temporary phase. Eventually, the producers and the labourers will correctly learn about the higher rate of inflation.
They will both incorporate this correct expectation into new labour contracts and the unemployment rate will return to its old natural level. Thus, there is no long run trade-off between inflation and unemployment.
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Thus, assuming that the rate of price inflation is equal to the rate of wage inflation, and that neither producers nor labourers suffer from money illusion, i.e., both correctly anticipate inflation, the Friedman- Phelps model implies
(a) That the anticipated changes in the price level will be fully incorporated into money wage contracts and
(b) That, as a consequence, the rate of change of money wages will be a function of both the unemployment rate and the anticipated rate of prices.
Eventually, both employers and labourers will realise that the actual inflation rate is 10 per cent per annum.
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New labour contracts will take this realisation into account and the unemployment rate will return to the natural level (5 per cent) and the economy moves from point B to point C.
The policy implication of the Friedman-Phelps model is that monetary policy (or fiscal policy) can affect employment and output in the short run because these policies can fool the people, i.e., can lead people to make errors in anticipating inflation, in the short run.
But, in the long run, these policies will become ineffective because, in the long run, employers and employees will fully and correctly anticipate the inflation rate and as a consequence, unemployment will return to its natural rate.