The unique Israeli capital market, which enables extraction of direct inflation expectations and unexpected inflation, is a comfortable setting to test Milton Friedman's hypothesis according to which inflation uncertainty positively affects unemployment in periods of time which vary from the short-term. The findings of this study are the first to provide significant empirical support for this hypothesis. The results reflect the medium-term trends and that the transfer mechanisms through which uncertainty affects unemployment are mainly private consumption and to a lesser degree private investment. This interpretation is consistent with the accepted theory, according to which in the very long-term uncertainty is less relevant.

The Phillips curve, which represents the correlation between unemployment and inflation, was first presented by Phillips (1958) and was adjusted by Phelps (1967) and Friedman (1968), to include the structured expectations in its framework.

The Phillips short-term curve enables substituting unemployment with unexpected inflation (defined as actual inflation with expectations removed) and creates positive/negative correlation for inflation expectations/inflation rate. In this framework, the increase in inflation beyond expectations causes temporary erosion of real wages and following this, a temporary demand for employment and a decrease in the unemployment rate. Alternatively, it can be said that an increase in the price of products leads manufacturers to erroneous decisions, due to gaps in information. According to this explanation, as long as manufacturers do not know if the price increase reflects an increase in the general level of prices or a relative increase, they choose the path of compromise and increase manufacturing only partially (compared to that which is requisite with relative price increases).

According to the rational expectations theory, average unexpected inflation in the long-term is not probable, and therefore, the long-term Phillips curve is perfectly inelastic. In other words, every change in the long-term money supply will generate an inflation reaction, but will not decrease the unemployment rate or increase the production. The assumption of no substitution (or neutrality of money) in the long-term has been studied in a large number of empirical studies, and is indeed, the prevailing view in current economic literature.

Monetary Economics Journal, Israeli Capital Market, Inflation Expectations, Economic Literature, Rational Expectations Theory, Resource Allocation Process, Economic Policies, Linkage Systems, Government Bonds, Empirical Generalized Least Squares Method, Error Correction Model, ECM, Private Consumptions.