Phelps's 1967 Expectations-Augmented Phillips Curve

Phelps’s Economica paper reached the natural-rate conclusion from a different direction than Friedman’s 1968 address, and reached it first. Where Friedman argued from the quantity theory and the logic of nominal-versus-real magnitudes, Phelps built up from the micro-behaviour of firms and workers setting wages under uncertainty about what others would do — an early expression of the search- and expectations-theoretic foundations that the New Classical program would later formalise. The two arrivals are usually bracketed together as the “Phelps-Friedman” natural-rate hypothesis precisely because their independence makes the conclusion harder to dismiss as one school’s predisposition.

The substantive claims: the apparent inflation-unemployment trade-off is not timeless but dynamic — buying lower unemployment today costs permanently higher inflation tomorrow; once agents learn to expect inflation, the whole Phillips Curve shifts up one-for-one; and so the only steady-state Phillips Curve is vertical at the equilibrium rate of unemployment. Phelps also pushed further than Friedman into the optimal inflation path over time — treating the inherited level of inflationary expectations as a state variable that current policy bequeaths to the future.

Phelps received the Nobel Memorial Prize in 2006 for this and related work on intertemporal trade-offs; his 2006 retrospective revisits the episode with four decades’ vantage.