TO THIS POINT, we have examined only anticipated increases in the fiat money stock. In this chapter, we examine the effects of monetary surprises—unanticipated fluctuations in the fiat money stock—on output, in particular. As we do so, we also study the more general question of how data correlations resulting from policy surprises may mislead naïve policy makers about the effects of the sustained implementation of their policies.
The Phillips Curve
In 1958, A. W. Phillips discovered a significant statistical link between inflation and unemployment for the United Kingdom over a century. Subsequent work uncovered the same correlation for many other economies. Although it was not understood why such a correlation existed, this discovery excited many in the economics profession by suggesting that there may be an exploitable trade-off between inflation and unemployment—that by increasing inflation, the government might achieve lower unemployment and greater output. The apparent inverse relationship between inflation and unemployment rates that existed in the United States data between 1948 and 1969 is illustrated in Figure 5.1.
In the following decades, many governments tried to use monetary policy to stimulate the economy. Suddenly, the Phillips curve, a stable relationship for more than a century, disappeared. Inflation occurred with no gains in output or employment. The disappearance of the stable relationship between the inflation rate and the unemployment rate becomes obvious when we look at U.S. data on these variables for the period from 1970 to the present, as shown in Figure 5.2.