Price-Level Uncertainty, Indexation and Employment

Abstract

Uncertainty about future price level is one of the most common features of today's economies. Yet, research on the relationship between and price changes focused on the level of those changes.' In his recent Nobel lecture on inflation and Milton Friedman suggested that increased variability of actual or anticipated inflation may raise the natural level of unemployment [6, 466]. Observing the tendency of inflation that is high on the average to be highly variable, Friedman suggested the relationship between and inflation uncertainty as a possibly explanation for the recently observed positive slope of the Philips curve. As possible remedies to the detrimental effect of inflation uncertainty, Friedman suggested a stabilization of the inflation rate (through, e.g., a stable monetary expansion) and the institution of price indexing. The purpose of this paper is to point at a possible relationship between price-level uncertainty and the real sector of the economy. It is shown that under plausible assumptions about individuals' preferences and attitude toward risk, an increase in price-level uncertainty may bring about a decrease in the level of employment and possibly an increase in unemployment, as suggested by Friedman. These results are also supported by empirical evidence.

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