Essay: Money Illusion

Friedman and Phelps suggest that workers’ are interested in real wage, “the inflation adjusted purchasing power of money wages” (Hoover, n.d.). If workers do not expect firms to increase prices as a result of increase in nominal wages (expected inflation is zero) then they may perceive an increase in their real income and supply more labor. The workers suffer from “money illusion”, unemployment would move to U1 and inflation to π1 thus reaching ‘point a’ as shown in Figure 3. (The Inflation Acceleration Controversy, n.d.)

However, this “money illusion” according to Friedman and Phelps would not last forever as workers would notice that there is no increase in their real wage and they would leave the market causing unemployment to return to U*.( point b in Figure 3). (The Inflation Acceleration Controversy, n.d.).

Friedman and Phelps in the Expectation Augmented Philips Curve model assume that people have adaptive expectations, that is, they base current inflation expectations on past inflation. As expected inflation is no longer zero the Philips curve moves upwards. “For each level of expectations, there is a specific “short-run” Phillips Curve” (The Inflation Acceleration Controversy, n.d.). For inflation expectation of π1  the new Philips Curve in Figure 3 is π= h(U)+β π1.