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Dynamic Economic Decision Making: Strategies for Financial Risk, Capital Markets, and Monetary Policy by JOHN E. SILVIA

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Chapter 7

Money, Interest Rates, and Financial Markets

Constant change and the evolution of our decision-making framework have been most obvious in private financial markets and public monetary policy. In the 1970s, unexpected inflation, volatility in interest rates, and a subsequent double dip recession were the combination of economic surprises and shocks that led to significant changes in the framework of the economy and mandated alterations in how to make decisions. Three questions face decision makers: How has the model of financial behavior changed over the years and where are we now? What are the barriers to effective decision making? What do the trends in financial markets tell us about our risks and opportunities going forward?

In 1958, A. W. Phillips, a New Zealand economist working at the London School of Economics, presented data showing a negative relationship between the unemployment rate and wage inflation in the United Kingdom.1 At that time, Phillips observed that periods of rising wage inflation were associated with lower unemployment and vice versa. By the mid-1970s, the traditional model of the Phillips Curve, which postulated a trade-off between inflation and unemployment, was breaking down. Today we associate periods of stronger real economic growth in the economy with higher inflation and lower unemployment.

Over time, however, during the 1960s and 1970s, the rise in inflation gave rise to rising inflation expectations and the trade-off between inflation ...

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