Surprise!

The New Classical economists solved the problem with a new insight about economic behavior. The insight is that people respond differently to the same stimulus, depending on whether that stimulus comes as a surprise to them or not. That may seem "common sense," but the New Classical economists gave it an importance and applications that common sense never gave it. In so doing, I believe they made a major discovery, which applies to economic behavior generally and which will continue to lead to new applications in the future. In effect, the New Classical economists discovered a new principle of economics in the last third of the twentieth century.

Of course, they applied it to inflation and the Friedman Curve in particular: Producers react differently depending on whether an increase in the price level comes as a surprise. If it does come as a surprise, then it takes some time for the input prices to catch up -- and in the meanwhile, it seems profitable to increase production. Therefore, production is greater at higher price levels. That is, the Friedman Curve is upward sloping.

According to New Classical economists, increased production would seem profitable when inflation comes as a surprise because

• Businessmen have incomplete information, and believe that the price increase is a relative price increase -- increasing their margin over costs -- when it is not.
• Contracts based on the old price level have some time to run, and while they are in force, it really is more profitable to increase production.
• If businessmen have adaptive expectations, then it takes some time for them to adjust their expectations even if they have complete information. However, most New Classical economists did not stress this reason, since they believed that businessmen had rational -- not adaptive -- expectations.

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