today. the 1960s'idea that greater prosperity could be achieved if only we were willing to accept higher inflation had its origins in an academic study, although the author likely did not intend that outcome. in 1958, a. w. phillips, using british data, showed that historically inflation had tended to be high in years in which unemployment was low. similar results were subsequently reported for the united states. 4 phillips did not draw strong policy conclusions from his findings. but that did not stop others from doing so. in the decade following the publication of his paper, his empirical finding was sometimes interpreted ( including, for example, by members of the kennedy and johnson administrations ) as showing that policymakers could choose ( permanently ) lower unemployment if they were willing to accept ( permanently ) higher inflation in exchange. scholars disagree somewhat about the extent to which policymakers of the time tried actively to take advantage of this supposed tradeoff, but these ideas likely provided part of the intellectual rationale that made the authorities willing to allow inflation to rise throughout the 1960s and in the early 1970s. the idea of the permanent tradeoff did not go unchallenged, however. in 1967, economists milton friedman and edmund phelps independently produced influential critiques of this view. their key contribution was to observe that, if inflation expectations react to changes in actual inflation in an economically reasonable way, then any tradeoff between inflation and unemployment would be shortlived at best. to illustrate their argument, let us suppose that firms and workers set nominal wages once a year but that, sometime during the year, the prices of firms'output rise unexpectedly as a result of stronger - than - expected demand. the combination of higher prices for their output and fixed nominal wages would raise the profitability of increasing production ; thus, assuming that more workers are available at the previously fixed wage, firms would respond to the rise in prices by adding workers. over a short period, then, higher inflation might bring lower unemployment, consistent with the empirical results found by phillips. however, this logic applies only during the period in which wages and workers'expectations of inflation are fixed. if inflation were to rise persistently, friedman and phelps argued, workers'expectations of inflation would not remain unchanged but would adjust to match the actual rate of inflation. higher inflation expectations would in turn lead workers to bargain for commensurate raises in nominal wages to preserve the real value of their earnings. with nominal wages rising as well as prices, firms would no longer have an incentive to

. in an environment of weak financial systems, lax supervisory regimes, and vague guarantees about depositor or creditor protections, bank runs have occurred in several countries and reached crisis proportions in indonesia. uncertainty and retrenchment have escalated. the state of confidence so necessary to the functioning of any economy has been torn asunder. vicious cycles of ever rising and reinforcing fears have become contagious. some exchange rates have fallen to levels that are understandable only in the context of a veritable collapse of confidence in the functioning of an economy. a similar breakdown was also evident in mexico three years ago, albeit to a somewhat lesser degree. in late 1994, the government was rapidly losing reserves in a vain effort to support a currency that had come under attack when the authorities failed to act expeditiously and convincingly to contain a burgeoning current account deficit financed in large part by substantial short - term flows denominated in dollars. these two recent crisis episodes have afforded us increasing insights into the dynamics of the evolving international financial system, though there is much we do not yet understand. with the new more sophisticated financial markets punishing errant government policy behavior far more profoundly than in the past, vicious cycles are evidently emerging more often. for once they are triggered, damage control is difficult. once the web of confidence, which supports the financial system, is breached, it is difficult to restore quickly. the loss of confidence can trigger rapid and disruptive changes in the pattern of finance, which, in turn, feeds back on exchange rates and asset prices. moreover, investor concerns that weaknesses revealed in one economy may be present in others that are similarly situated means that the loss of confidence can quickly spread to other countries. at one point the economic system appears stable, the next it behaves as though a dam has reached a breaking point, and water ( read, confidence ) evacuates its reservoir. the united states experienced such a sudden change with the decline in stock prices of more than 20 percent on october 19, 1987. there is no credible scenario that can readily explain so abrupt a change in the fundamentals of long - term valuation on that one day. such market panic does not appear to reflect a simple continuum from the immediately previous period. the abrupt onset of such implosions suggests the possibility that there is a marked dividing line for confidence. when crossed, prices slip into free fall - - perhaps overshooting the long - term equilibrium - before markets will stabilize. but why