The

Vol. 16 | No. 2 | 165–186

Quarterly Summer 2013
Journal of
Austrian
Economics

Dynamic Monetary Theory and the

Phillips Curve with a Positive Slope
Adrián O. Ravier

ABSTRACT: Don Bellante and Roger W. Garrison (1988) compared two

alternative explanations of monetary dynamics: those based on a vertical
long-run Phillips curve and those derived from analysis of Hayekian
triangles. The authors concluded that the only factor differentiating the two
models is the “process” whereby the initial cause is converted into the final
“neutral” effect. This article refutes that conclusion. To do so, it suffices to
demonstrate that the long-term effect of monetary policy is never neutral.
While it is true that after the boom and bust the economy returns to the
natural rate of unemployment, the crucial point is that the “natural rate” at
the end of the cycle is quite different from the one evident at the start. This
requires an “Austrian” Phillips curve with a positive slope.
KEYWORDS: monetary dynamics, Phillips curve, unemployment,
business cycle

JEL CLASSIFICATION: B25, E24, E32, E58, N12

Adrian Ravier ([email protected]) holds a Ph.D. in applied economics from the

University Rey Juan Carlos in Madrid and is Professor of the School of Business at
Francisco Marroquín University, Guatemala. The author gratefully acknowledges
the helpful insights of an anonymous reviewer and comments made on an earlier
draft of this paper by Christopher Lingle, Nicolás Cachanosky and Andrew Reed.
The author retains sole responsibility for any remaining shortcomings.

165
166 The Quarterly Journal of Austrian Economics 16, No. 2 (2013)

INTRODUCTION

D on Bellante and Roger W. Garrison (1988) use a vertical

long-run Phillips curve and Hayekian triangles to illustrate
two alternative explanations of dynamic monetary theory. The
conclusion the authors reached is that it is only the “process”
whereby the initial cause is converted into the ultimate “neutral”
effect that distinguishes the two approaches. This article challenges
that conclusion on the grounds that monetary policy is never
neutral in the long run. While it is true that the economy returns
to the natural rate of unemployment after a boom-bust cycle, the
post-boom “natural rate” is not the same as the one that preceded
the cycle. This implies a long-term Phillips curve with a positive
slope, consistent with Austrian business cycle theory.
In Part I we summarize the traditional debate over the Phillips
curve as it relates to dynamic monetary theory. In Part II we outline
the Bellante-Garrison argument based on the relationship between
Hayekian triangles and the Phillips curve. In Part III we explain why
the effect of monetary policy is not neutral in the long term, and why
this supports a theoretical model with an upward sloping Phillips
curve. In Part IV we close with the implications of the study.

PART I: THE DEBATE OVER THE PHILLIPS CURVE.

The empirical work of Alban William Housego Phillips (1958)
initiated one of the most important debates in modern macroeco-
nomics and politics. A Phillips curve describes the relationship
between consumer price inflation and unemployment at various
stages in an economic cycle. The Keynesian Phillips curve with a
negative slope, shown in Figure 1, illustrates the tradeoff policy
makers allegedly face. They may choose a low level of unem-
ployment, UL, as long as they accept a higher level of prices. Alter-
natively, when price inflation becomes the dominant problem,
they can diminish its acceleration, even to the point of deflation.
However, in that case they necessarily have to accept a higher
level of unemployment: U0 for inflation zero, UH for deflation. This
tradeoff implies a negatively sloped Phillips curve.
Phillips’ (1958) analysis of empirical data was invoked to support
the Keynesian policy prescription: counter-cyclical application of
Adrián O. Ravier: Dynamic Monetary Theory and the Phillips Curve… 167

quantitative easing which capitalizes on the non-neutral impact of

monetary policy in the short run.
Phillips’ tradeoff hypothesis was questioned from three distinct
perspectives. The first category involved the theoretical challenges
mounted by monetarists led by Milton Friedman, and Austrian
economists led by Friedrich Hayek. The second challenged the
broader validity of the model, inferring that its applicability to
North America allegedly demonstrated by Samuelson-Solow
(1960) was a special case.1 The third was evidence of simultaneous
high unemployment and high inflation, the phenomenon known
as “stagflation.” As Milton Friedman himself pointed out, “stag-
flation” “rendered somewhat ludicrous the confident statements
that many economists had made about ‘trade-offs,’ based on
empirically-fitted Phillips curves.” (1975, p. 50)

Figure 1. T
 he Keynesian Phillips Curve

Rate of Price Change

1 dp
P dt
A

Unemployment
0
UL U0 UH

These challenges produced what Milton Friedman (1977) called

the monetarist counter-revolution. The monetarist alternative

1
I t was generally inferred that the work on the North American economy by Paul
Samuelson and Robert Solow (1960) gave credence to a Phillips curve with a
negative slope. However, their own work supported criticism of this inference:
they acknowledged that the Phillips curve trade-off in the U.S. economy offered
only short-run benefits at best, exhibited instability over many periods they
examined, and was frequently upward-sloping (i.e., for many periods higher
inflation appeared to cause higher unemployment rather than lowering it).
(Samuelson and Solow, 1960, pp. 188–190)
 Ravier1

168 The Quarterly Journal of Austrian Economics 16, No. 2 (2013)

acknowledged the validity of Keynesian manipulation of the

money supply in the short term but considered the implication of
a vertical Phillips curve. This research highlighted the distinction
between the effect of monetary policy in the short and long terms,
as well as the difference that exists between nominal and real
variables. The results emphasized the importance of the neutrality
of money in the long term and monetary policy lags (Friedman,
1961). They also prompted speculation over the existence of a
“natural” rate of employment and theories of adaptive expec-
tations and inflation acceleration.
The vertical “monetarist” Phillips curve is presented in Figure 2.
Starting from point E, let us assume that the economy in question
has never experienced inflation. Under these conditions, and
assuming a process of adaptive expectations, the most reasonable
outcome is an expectation of zero inflation in period 1.
The curve representing the expected inflation rate determines
the level of unemployment, e.g. UN (natural rate). However, if poli-
cymakers resolve to diminish the level of unemployment in the
economy, for example to UL, using sufficiently expansive monetary
policy, this would generate a price increase at a rate of 1 dP
A=
(point F). P dt

Figure 2. E
 xpectations-Adjusted Phillips Curve

Rate of Inflation

1 dp
P dt

H I
B

A
F G ( 1P dp
dt )
**
=B

UL
E
UN
( 1P dp
dt )
*
=A

Unemployment ( 1P dp
dt )
=0
Adrián O. Ravier: Dynamic Monetary Theory and the Phillips Curve… 169

Any attempt to maintain an unemployment rate lower than UN

can only succeed if the economy is subjected to inflation at an Ravier2
increasing rate. This is necessary in order to keep the inflation
rate permanently above the level agents anticipate, based on
previous experience.
Friedman called this reasoning “the acceleration hypothesis,” a
hypothesis originally proposed by Hayek (1978 [1958]).2 This way
of approaching the problem quickly led to the conclusion that the
level of employment was a function of inflation not anticipated by
economic agents or, more rigorously, the difference between the
current unemployment rate and the natural rate of unemployment
is a function of the “rate of unanticipated inflation.”
Chicago economists concluded that the Keynesian Phillips curve
may be effective in the short term when the rate of inflation is not
factored into decisions made by economic agents. However, if
expansionary monetary policy continues, its impact will tend to be
negated by adaptive expectations. In the long run, therefore, unem-
ployment would remain “stuck” at the “natural rate,” implying a
vertical Phillips curve.
The logic behind this reasoning depends on the assumption that,
in the long term, agents will correctly anticipate the inflation rate
unless they are “surprised” by continuously accelerating inflation.
If monetary stimulus is not used to thwart the expectation that a
constant rate of inflation is the objective, then the expected rate
of inflation will converge with observed value 1 dP * 1 dP
P dt
=
( ) ( )
P dt .

2
See Chapter XXI, in Studies of Philosophy, Politics and Economics (1978). However,
Hayek questioned the practical validity of the acceleration hypothesis. “First, such
inflation, in order to achieve the goal aimed at, would have to accelerate constantly,
and accelerating inflation would sooner or later reach a degree that makes all
effective order of a market economy impossible. Second, and more important, in
the long run such inflation inevitably creates much more unemployment than the
amount it was originally designed to prevent.” Elsewhere he wrote: “The chief
conclusion I want to demonstrate is that the longer the inflation lasts, the larger will
be the number of workers whose jobs depend on a continuation of the inflation, often
even on a continuing acceleration of the rate of inflation—not because they would not
have found employment without the inflation, but because they were drawn by the
inflation into temporarily attractive jobs, which after a slowing down or cessation of
the inflation, will again disappear.” (Hayek, 1979, pp. 11–13) The latter quotation is
also relevant in the context of the argument presented in Part III.
170 The Quarterly Journal of Austrian Economics 16, No. 2 (2013)

When this is the case, the relationship is expressed by a Phillips

curve which is a vertical line at the point where the natural rate of
unemployment (UN) occurs.
The economic policy consequence of this analysis is obvious:
active manipulation of the money supply to continuously reduce
unemployment is doomed to fail in the long term because it will
either launch the economy on a path of rampant inflation (if an
attempt is made to successively “surprise” economic agents by
accelerating inflation rates) or fail to reduce unemployment below
its “natural level” (if a constant rate of inflation is maintained).
The monetarist version of the Phillips curve was simultaneously
rejected and reinforced by the work of Robert Lucas of the
University of Chicago, Thomas Sargent of the Hoover Institution,
and others who became known as New Classical macroeconomists.
(See especially Lucas and Sargent [1978]) Essentially, the modifi-
cations they advocated were a shift from the concept of adaptive
expectations to one of rational expectations, and acceptance of
the neutrality of money (in both the short and long term) as a key
assumption. If agents form their expectations rationally, there is no
reason to assume that they can be fooled by inflationary policy in
either the long or the short term. Under this assumption, the real
and positive effects on employment in the short term disappear
and the Phillips curve is vertical, irrespective of whether the long
or short-term consequences are involved.

PART II: THE BELLANTE-GARRISON COMPARISON

Bellante and Garrison (1988) compared monetarist work on the
Phillips curve with the dynamic monetary theory of Friedrich
Hayek, illustrated by Hayekian triangles (Hayek, 1931). Following
Hicks (1967, p. 203), they pointed out that Hayek’s theory was the
dominant alternative to those of Keynes until it was eclipsed by
Friedman’s monetarist theories. From that point on, monetarist
theories were regarded as the main alternative to Keynesianism.

In general, Monetarists have taken comfort in the Knightian view that

the structure of capital, particularly the inter-temporal structure, can be
safely ignored, and that theories in the Austrian tradition, which make
use of such concepts as “roundaboutness” and “stages of production,”
are especially misguided. (Bellante and Garrison, 1988, p. 210)
Adrián O. Ravier: Dynamic Monetary Theory and the Phillips Curve… 171

If John Bates Clark (1924) and Frank Knight (1934, 1944) provided
the Chicago School with its theory of homogeneous capital, it was
in the work of Carl Menger (1871) and Eugen von Böhm Bawerk
(1889) that the implications of a theory of heterogeneous capital
originated. Austrian capital theory highlights the fundamental
differences between the two approaches (Garrison, 1990).
It is true that coincidental similarities arise between Hayek and
Friedman. The most obvious is recognition that rigidities in labor
markets prevent perfect and instantaneous market adjustments to
monetary distortions. Both also reject the presumption of rational
expectations, which would otherwise allow agents to anticipate
monetary policy and avoid the “surprise” effect in both the short
and long terms. But these similarities only serve to highlight the
differences that arise from the distinct capital theories the Austrian
and Chicago schools use to explain the process that ultimately
produces a “neutral” impact.
Bellante and Garrison (1988, p. 219) enumerate the similarities
as follows:

Five points of commonality are noteworthy: (1) Both theories can be

fully squared with the kernel of truth in the quantity theory of money. (2)
Both theories deal with disequilibrium phenomena, but neither denies
that equilibrating forces dominate in the end. (3) Both hinge in a critical
way on the distinction between short-run effects and long-run effects. (4)
Both involve a market process that is necessarily, or endogenously, self-
reversing. Monetary disturbances cause certain kinds of distortions in
market signals. These distortions give rise in the short run to movements
in certain prices and quantities, movements which in the long run create
market conditions for counter-movements in those same prices and quan-
tities. (5) With appropriate qualifications (about what constitutes the long-run)
both theories are characterized by monetary disturbances whose short-run effects
are non-neutral but whose long-run effects are neutral” (emphasis added).

Bellante and Garrison (1988) also point out that the “long term”
in the Hayekian approach needs to involve a lapse of time sufficient
for the relationship between capital and labor to be realigned after
mal-investments of capital have been liquidated.
More fundamentally, Bellante and Garrison (1988) explain that
in the last phase of the adjustment process, the economy enters a
period of crisis and depression. But over time, only a portion of the
capital stock can be reallocated to satisfy demand consistent with
172 The Quarterly Journal of Austrian Economics 16, No. 2 (2013)

the new structure of capital. Eventually, after this restructuring

and the elimination of distortions, the new capital structure again
reflects genuine resource availabilities, namely the actual supply
and demand of loanable funds. Bellante and Garrison (1988, p.
217) concluded:

Abstracting from the capital that is lost forever as a result of the credit
expansion and from possible long-run effects on the distribution of
income, the rate of interest and the corresponding structure of production
will return to the level and configuration that characterized the economy
before the credit expansion.

This is precisely the neutrality problem Garrison addressed

in the model he presented in Time and Money. (2001; see also the
discussion in Ravier, 2011a)
Bellante and Garrison imply that the non-neutral effect in the
long run is limited to the structure of production. They consider the
post-bust structure of production a function of interest rates that
have returned to their pre-boom level and a reduced capital stock.
But the credit market cannot be disassociated from the structure of
production, as Hayek explained in his correspondence with Keynes
in the thirties. The realignment of the credit market with the new
structure of production requires real interest rates that are higher
than their pre-boom level. Bellante and Garrison (1988) should
therefore have seen that Friedman and the monetarists were wrong
about the neutrality of money, especially in the very long term.

PART III: THE POSITIVE SLOPE OF THE PHILLIPS CURVE

As Bellante and Garrison (1988) remind us, Friedman
acknowledged that irresponsible monetary policy would even-
tually lead to an increase in the natural rate of unemployment. Two
of Friedman’s papers (1976, pp. 232–233 and 1977, pp. 459–460)
suggested the potential existence of a positively sloped Phillips
curve. But in neither case did Friedman reconsider his model of
dynamic monetary theory in light of his empirical work.
In his Nobel lecture, Friedman acknowledged that additional
research was needed to resolve the inconsistency between the
monetarist Phillips curve and empirical data. He anticipated that
this “third stage” of the research into the relationship between
Adrián O. Ravier: Dynamic Monetary Theory and the Phillips Curve… 173

inflation and unemployment would only be successful if a way

was found to incorporate political factors:

In recent years, higher inflation has often been accompanied by higher not
lower unemployment, especially for periods of several years in length.
A simple statistical Phillips curve for such periods seems to be positively
sloped, not vertical. The third stage is directed at accommodating this
apparent empirical phenomenon. To do so, I suspect that it will have
to include in the analysis the interdependence of economic experience
and political developments. It will have to treat at least some political
phenomena not as independent variables—as exogenous variables
in econometric jargon—but as themselves determined by economic
events—as endogenous variables [...]. The third stage will, I believe, be
greatly influenced by a third major development—the application of
economic analysis to political behavior, a field in which pioneering work
has also been done by Stigler and Becker as well as by Kenneth Arrow,
Duncan Black, Anthony Downs, James Buchanan, Gordon Tullock, and
others. (1977, p. 470)

In my doctoral thesis (Ravier, 2010), I called this “Friedman’s

dilemma” because Friedman observed an empirical reality his own
analytical framework was unable to explain. Friedman observes a
positively sloped Phillips curve and a long-term effect of monetary
stimulus which is not neutral in real terms. Both are inconsistent
with his own theories. Instead he provides evidence confirming the
work of Robert Lucas (1973) and, more recently, William Niskanen
(2002). Robert Mulligan (2011) has demonstrated the connection
between Niskanen’s article and Austrian business cycle theory.3
In fact, Hayek wrote extensively on this topic, but did not attempt
to formalize it in terms of the Phillips curve. In The Campaign
Against Keynesian Inflation, he explained:

3
“ William Niskanen (2002) estimated a Phillips curve for the United States using
annual 1960–2000 data. By adding one-year lagged terms in unemployment and
inflation, he was able to show that this familiar equation is mis-specified. In his
improved specification, Niskanen found that the immediate impact of inflation
is to reduce unemployment, confirming the traditional understanding of the
Phillips-curve relationship, but also finding that after an interval as short as one
year inflation has generally been followed by increased unemployment. Though
Niskanen was perhaps unaware of it, his results lend strong support to the Austrian
model of the business cycle. In that model, credit expansion results in a temporary
but unsustainable expansion. Unemployment is lowered in the short run, but once
the policy-induced mal-investment is recognized, total output and income will be
permanently reduced, and unemployment will increase.” (Mulligan, 2011, p. 87)
174 The Quarterly Journal of Austrian Economics 16, No. 2 (2013)

The Keynesian dream is gone even if its ghost continues to plague politics for
decades. It were to be wished that the words “full employment” them-
selves, which have become so closely associated with the inflationist
policy, should be abandoned—or that we should at least remember the
sense in which this was the aim of classical economists long before Keynes:
John Stuart Mill reports in his autobiography how “full employment
with high wages” appeared to him in his youth as the chief desideratum
of economic policy. What we must now be clear about is that our aim
must not be that maximum of employment which can be achieved in
the short run, but a “high and stable level of employment,” as one of
the post-war British White Papers on employment policy still phrased
it. This, however, we can achieve only through the re-establishment of a
properly functioning market which, by the free play of prices and wages,
secures in each sector a correspondence of supply and demand. Though
it must remain one of the chief tasks of monetary policy to prevent great
fluctuations of the quantity of money or the volume of the income stream,
the effect on employment must not be the dominating consideration
guiding it. The primary aim must again become the stability of the
value of money and the currency authorities must again be effectively
protected against that political pressure which today forces them so often
to take measures which are politically advantageous in the short run but
harmful in the long run. (Hayek, 1978, pp. 207–208)

In the following paragraphs, we explain the rationale behind the

Austrian Phillips curve with a positive slope. But to do this, we first
need to clarify a concept central to discussion of the Phillips curve
with adaptive expectations: “the natural rate of unemployment.”
Even though Milton Friedman developed this concept with
Wicksell’s “natural rate of interest” in mind, it is important to
recognize that there is really nothing “natural” about this special
rate of unemployment.4 This “natural” rate has several implicit
precursors, such as labor legislation (especially the minimum
wage), the monopoly power of unions, and efficiency wages,5

4
I n his Nobel Prize Lecture, Friedman explained: “The ‘natural rate of unem-
ployment,’ a term I introduced to parallel Knut Wicksell’s ‘natural rate of interest,’
is not a numerical constant but depends on ‘real’ as opposed to monetary factors—
the effectiveness of the labor market, the extent of competition or monopoly,
the barriers or encouragements to working in various occupations, and so on.”
(Friedman, 1977, p. 273)
5
“Efficiency-wage theories propose a third cause of wage rigidity in addition to
minimum-wage laws and unionization. These theories hold that high wages make
workers more productive. The influence of wages on worker efficiency may explain
the failure of firms to cut wages despite an excess supply of labor. Even though a
Adrián O. Ravier: Dynamic Monetary Theory and the Phillips Curve… 175

all of which represent rigidities in the labor market. (Mankiw,

2001, p. 162)6 In the absence of these labor market rigidities, full
employment would be the true “natural” rate. Figure 3 makes this
relationship explicit:

Figure 3. L
 abor Market and “Natural” Unemployment

“Natural”
Unemployment S
W/P

Minimum
Wage
W/P*

Od Os

This is the familiar textbook example showing the impact of a

minimum wage set above the actual market wage, causing disequi-
librium or unemployment. (Mankiw, 2001, p. 162) This is what
Friedman calls “natural unemployment,” determined by local
characteristics or other structural rigidities in the labor market.
From this point, we consider the impact of expansive credit
policy and its impact on the labor market following a sequence of
steps consistent with Austrian business cycle theory.
Garrison (2001), following Mises (1912) and Hayek (1931), points
out that an expansionary credit policy results in an interest rate
which is below its “natural” level. Investment expands without a
corresponding increase in savings, which makes the subsequent
boom unsustainable. But in the short term, the lower interest rate

wage reduction would lower a firm’s wage bill, it would also—if these theories are
correct—lower worker productivity and the firm’s profits” (Mankiw, 2001, p. 166).
6
 ome authors, such as Mankiw, prefer to show a vertically sloped curve of labor
S
supply, but this does not change the conclusion.
176 The Quarterly Journal of Austrian Economics 16, No. 2 (2013)

allows entrepreneurs to increase investment, which also increases

the demand for labor. In Figure 4 we show the movement of the
demand curve once monetary policy increases demand for labor
across the entire spectrum of employment.
Unemployment is reduced, at least temporarily. In the short
term, even real wages increase until inflation takes hold, due to
the lagged impact of monetary policy. Friedman would say that
this situation is only sustainable because the change in monetary
policy “surprised” economic agents, but once they adjust their
expectations, the loss of purchasing power is “neutralized” and
employment returns to prior levels.

Figure 4. M
 onetary Policy and Less Unemployment in the
Short-Term

Less
Unemployment S
W/P

Minimum
Wage
W/P*

D’
D

Od Od’ Os

It is at this point that the divergence of opinion occurs. The

Austrian explanation may be summarized as follows:

On the other hand, and this is the most relevant aspect, due to the mal-
investment process during the stimulus phase we also face a situation in
which the potential productive capacity of the economy (and thus the
real wages potentially earned once the economy returns to normal levels
of employment) is reduced as a consequence of the partial destruction
of capital. Many authors, including for example Huerta de Soto (1998,
pp. 413–415), focus attention on the “partial destruction of capital” that
inevitably occurs because there is a category of resources which are
lost when investment projects are abandoned. Stimulus significantly
Adrián O. Ravier: Dynamic Monetary Theory and the Phillips Curve… 177

increases the volume of resources that ultimately fall in the “sunk cost”
category: at the end of the stimulus phase, some resources have already
been committed to investment projects but are not yet productive; when
the stimulus phase ends and it turns out that these projects are not going
to be completed, these resources are “sunk” costs and not re-assignable
to new projects. (Ravier, 2011b, p. 369)

Microeconomic theory explains that the level of real wages

depends on capital accumulation and the productivity gains
achieved by productive investment in the economy. The Austrian
theory of the business cycle explains not only why the process of
boom, crisis, and depression ends with widespread unemployment,
but also why it destroys some portion of the capital mobilized by
the boom. Real wages fall because destruction of capital ultimately
reduces the productivity of workers.
In comparison with the situation prior to the boom-bust cycle,
demand for labor will be reduced at each level of real wages. This
is shown in Figure 5.
Under the empirical assumption that the real minimum wage
remains constant through the boom and bust phases, more
workers are now excluded from the formal labor market. The
explanation lies in the reduced aggregate productivity of workers
which results from the partial destruction of capital experienced
by the economy.

Figure 5. C
 apital Destruction and More Unemployment in the
Long-Term

New Natural
Unemployment S
W/P

Minimum
W/P* Wage
W/P**

D
D’
Od’ Od Os
178 The Quarterly Journal of Austrian Economics 16, No. 2 (2013)

Once malinvestments are liquidated, workers may be re-hired

only if they accept lower real wages. A return to the previous level
of real wages will require a new process of capital formation, which
will only be “genuine”—and hence sustainable over time—if it is
again based on voluntary savings. Attempting to restore the real
wage level using a new injection of artificial credit is only effective
temporarily because an artificial boom is simultaneously launched.
With this in mind, the implications of Figure 6, the Austrian
Phillips curve with a positive slope, become clear. Let us suppose
that we start from point A, with a low level of inflation and its
associated “natural” rate of unemployment.

Figure 6. A
 Phillips Curve with a Positive Slope: A Possible
Solution to Friedman´s Dilemma
Inflation
Rate
�4
F G

�3
D E
�2
B C
�1 A
�0 B* U1 U2 U3 U4 Unemployment
U* Rate
Deflation
Rate Frictional Real Wage Rigidity and
Unemployment Structural Unemployment

In the tradition of the Austrian School, the only way to truly

achieve a stable situation and full employment is by adhering to a
neutral monetary policy (which enables investments to match the
level of savings) while providing absolute flexibility in the labor
market (by eradicating all labor laws, including any minimum
wage). If this happens, the economy would move from point A to
point B* via a genuine process of capital formation. This results in
increased productivity and is consistent with “growth deflation.”
(Salerno, 2002)7

7
 ee also George Selgin (1997) and Lawrence H. White (2008). The latter offers the
S
following example: “Between 1880 and 1900 the United States experienced one of
Adrián O. Ravier: Dynamic Monetary Theory and the Phillips Curve… 179

There is, however, an alternative which may achieve full

employment in the short term, but only by sacrificing price
stability and giving rise to some distortions in the economy. This
is once again the Keynesian prescription: monetary policies that
stimulate demand do create jobs, but achieve full employment
only by reducing real wages.
As explained above, both the Keynesian and monetarist models
show that governments can use monetary policy to move from A
to B (in Figure 6), but only at the expense of the inflationary impact
of those same monetary policies. We need to acknowledge that
Krugman (2010) was to some extent correct when he suggested
that Austrians are Keynesians during booms.
Friedman (1977) claimed that these effects would only mate-
rialize in the short term, but in the long term would be neutralized,
returning unemployment to its “natural” rate. This is the crucial
question: will the economy return to the same pre-boom “natural”
rate of unemployment, or will the “natural” rate be altered by the
detour to full employment and the subsequent adjustment process?
Is the effect really neutral in the long term?
In confronting the long-term neutrality of money, we are tackling
one of the most widely accepted assumptions in modern macro-
economics. It should be acknowledged that the new Keynesians
and monetarists accept some non-neutrality in the short term,
but in the long run both believe those effects disappear. The Real
Business Cycle theory of the New Classical macroeconomists
assumes rational expectations and therefore necessarily rejects
non-neutrality in both the short and long term.
The literature on non-neutrality has its roots in the Cantillon
Effect, which is the distortion of relative prices and redistribution
of income that occurs when liquidity is injected into the market
(Cantillon, 1755). The impact of forced savings, introduced by Jeremy
Bentham but revived by Hayek and extended by Horwitz (2000,

the most prolonged periods of deflation on record. The price level trended more or
less steadily downward, beginning at 6.10 and ending at 5.49 (GDP deflator, base
year 2000 = 100). That works out to a total decline of 10 percent stretched over 20
years. The deflationary period was no disaster for the real economy. Real output
per capita began the period at $3,379 and ended it at $4,943 (both in 2000 dollars).
Total real per capita growth was thus a more than healthy 46 percent. (Real GDP
itself more than doubled.)” (White, 2008, p. 4)
180 The Quarterly Journal of Austrian Economics 16, No. 2 (2013)

p. 15), and the “money illusion” (Patinkin, 1987), which involves

the degree to which people are able to distinguish between real
and nominal variables, also contribute to, and are consistent with,
non-neutrality.
The impediment to adjustment during the “bust” phase of the cycle
that usually receives the greatest attention is the “stickiness” of prices
and long-term contracts. Wage contracts are denominated in nominal
terms. If actual price inflation exceeds the expectation of inflation,
then real wages fall. If workers observe this, they may reduce their
productivity. Alternatively, they may claim redress through unions,
but rigidities in the labor market (including the duration of labor
contracts) mean that any adjustments will take time.
In principle, the destruction of capital is consistent with lower
real wages. If we assume that the minimum wage remains constant
in real terms, after a boom and bust cycle more people “earn”
income below the legal minimum and automatically lose their
jobs. Unemployment is thus greater than in the initial situation.
However, minimum wages are also expressed in nominal terms.
The return to the “natural” rate of unemployment can be explained
by assuming that the adjustment process is completed, that mal-
investment is liquidated and that unemployed workers find new
jobs. But the structure of production is no longer the same as it
was before the boom and subsequent bust. It is for this reason that
workers receive lower real wages. The destruction of capital shifts
the production possibilities frontier (PPF) to the left, and produc-
tivity is reduced in the process. (Ravier, 2011b)
A return to the initial situation in terms of real wages requires a
genuine process of capital formation based on savings. This takes
time. Garrison and Bellante do not ignore the effect monetary
stimulus has on the structure of production, but they do not
recognize that the final result of the boom-bust cycle is substan-
tively different from the pre-boom situation. Monetarists are unable
to explain the mysterious reason why the same equilibrium that
existed before the monetary expansion took place miraculously
reappears after short term distortions dissipate. (Ravier, 2011a)
Austrians do explain why the same equilibrium does not reappear,
and the non-neutrality of money that the Hayekian triangles
illustrate is crucial to that explanation.
Adrián O. Ravier: Dynamic Monetary Theory and the Phillips Curve… 181

Figure 6 shows that the economy does return to its “natural”

state, but we must emphasize once again that there is no longer
anything ‘natural’ about the unemployment rate associated with
that state: it is a product of imposed rigidities and moves further
and further from full employment with the adjustment that follows
each monetary stimulus. In fact, the loss of employment is usually
exacerbated because rigidities are often increased during the
adjustment phase, a political reaction to the difficulties monetary
expansion inevitably causes.
It is crucial to remember that for the Austrian School, the effect
is not just nominal and restricted to prices. Unemployment also
rises, as shown in Figure 6, from point B to point C, which is higher
than the initial point A. If the government again insists on imple-
menting expansionary monetary and credit policies in an attempt
to prevent deflation and crisis by means of stimulus, then a new
cycle begins which will speed the economy towards a new level
of inflation and increasing unemployment, perhaps reaching point
D in the short term, to then settle down at the point E once the
subsequent adjustment is completed.
This suggests two implications: 1) the theoretical Phillips curve
slope should be positive, as Friedman suggested, and 2) in the
context of economic policy, the government should not increase the
money supply if its objective is sustainable economic growth and
development. Ultimately, as Mises (1949) pointed out, government
intervention invariably generates results which are precisely the
opposite of those sought.

PART IV: CONCLUSIONS

In his Nobel Prize Lecture, Friedman concluded:

Much current economic research is devoted to exploring various aspects

of... the dynamics of the process, the formation of expectations, and the
kind of systematic policy, if any, that can have a predictable effect on real
magnitudes. (emphasis added) (1977, p. 459)

Here we suggest an advance in the direction suggested. In this

article we show that the non-neutrality of money in the long term
is the crucial concept when explaining the divergent views of the
182 The Quarterly Journal of Austrian Economics 16, No. 2 (2013)

Chicago and Vienna Schools on the impact of monetary stimulus.

(Ravier, 2011a and 2011b)
Friedman’s work illustrates the limitations of the Chicago
School’s analytical framework for understanding problems related
to the economic cycle. Therefore, although we acknowledge
certain elements common to both traditions (Schenone and Ravier,
2007), we suggest Chicago theorists would benefit from adopting a
subjective and heterogeneous capital theory (Lachmann, 1955), the
Austrian theory of the business cycle and the concept of subjective
(as opposed to “adaptive” or “rational”) expectations (Shackle,
1949; Lachmann, 1955; Crespo, 1998; Garrison, 2001).
Finally, current U.S. unemployment difficulties may well have
their roots in the monetary policy of short term interest rates
pursued by the Federal Reserve in response to a succession of
crises (Krugman, 2002). The financial tsunamis of the Wall Street
stock market crash of October 19, 1987, the dot-com crisis in 2001,
and the subprime crisis of 2008 provide empirical evidence for
the theoretical derivation of a Phillips curve with a positive slope
presented here (Ravier and Lewin, 2012). The link between these
financial tsunamis and the Austrian Phillips Curve deserves more
thorough investigation.

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