Edmund S. Phelps: Our new Nobel Laureate

Three weeks ago The Royal Swedish Academy of Sciences announced that Edmund S. Phelps, the Columbia University economics professor, was awarded the 2006 Nobel Memorial Prize in Economic Sciences. The prize was awarded for research made during the 1960's about the long-run and short-run effects of government economic policies. At that time the economic academic environment was totally influenced by the Keynesian Revolution (still today our economic thoughts are almost Keynesian), a revolution in macroeconomics started by the great British economist John Maynard Keynes who in 1936 published the extraordinary treatise "The General Theory of Employment, Interest and Money". This book unraveled the fallacies of the old economic theories (Elizabethan and Victorian) and at the same time it is the foundation of a new theory that was well accepted by all. "The General Theory of Employment, Interest and Money" is comparable to Emmanuel Kant's 1781 book "Critique of Pure Reason" in the sense that both books started a new revolution in their respective areas: The General Theory changed our ideas about economic theory and the Critique changed our understanding of the theory of knowledge.

Today, I would like to sketch the contribution of Edmund S. Phelps to the macroeconomic theory of our times. It all started with the Phillips Curve. I am sure that you have heard about the Phillips Curve in your Intro to Economics back in your undergraduate years.

Based on the General Theory, the New Zealand economist Alban W. Phillips in 1958 developed the relationship between the rate of inflation and the rate of unemployment. According to Phillips there is always an inverse relationship between the rate of inflation an the rate of unemployment in any developed economy during any reasonable period of time. This relationship is called the Phillips Curve.

For many economists the Phillips Curve represents an important milestone in macroeconomics. Phillips developed this theory based on data of unemployment and wages in the United Kingdom from 1861 to 1957. His paper "The Relationship between unemployment and the rate of change of money wages in the UK 1861-1957" was publish in 1958. He found that when unemployment was high the wages increased slowly (the employers did have a big pool of unemployed workers after all), so the rate of inflation remains low; when unemployment was low, wages rose rapidly (the employers needed to attract the few unemployed workers), so the inflation (due to higher wages) rose as well.

Figure 1 shows such a curve (fitted) from 1961 to 1969 for the US economy (this figure is taken from an article published in the Concise Encyclopedia of Economics by Kevin. D. Hoover from the University of California at Davis).

Fig. 1: The Phillips Curve from 1961 to 1969 in the USA

As we see, the curve is steeper for lower unemployment rates than for higher unemployment rates. Because of this fact, many economists, during the 1960's, promoted the idea that the government could stimulate the economy when there is a high unemployment rate. If, for example, the unemployment rate is around 6 percent, the government could stimulate the economy by forcing the lowering of the unemployment rate to 5 percent. From the curve we see that this will cost the country an increase in the inflation rate of less than 0.5 percent. A reduction of 1 percent in the unemployment rate when the rate is 4 percent (from 4 to 3 percent) will increase the inflation rate substantially (more than 2 percent).

The Phillips Curve did very well for many years after it inception, but at the beginning of the 1960's, two economists - Edmund Phelps (winner of this year's Nobel Prize) and Milton Friedman (winner of the 1976 Nobel Prize) - disagreed with the general concept of the Phillips Curve. To explain their dissagreemnt, both - independently - introduced the concept of the "natural rate of unemployment" and the concept of "inflationary expectation". The natural rate of unemployment is defined as the rate of unemployment at which the inflation (and the wages) will remain at the same level; in other words, it is the level the wages will make the supply of labor equal to the demand for labor. Inflationary expectation is explained as the idea that the workers and the companies have learned that inflation would continue to rise and they have the expectation that inflation would increase if unemploymnet would fall. Therefore, based on this idea, the workers would ask for higher wages once unemployment is falling because they have the expectation that inflation will rise due to this unemployment fall.

Phelps's and Friedman's ideas could not be proved at the time, but a decade latter, during the 1970's we experienced a period of high unemployment and high inflation (the economists called it stagnation). In 1976, for example, the inflation was over 9 percent and the unemployment was over 8 percent. This, clearly, is in total contradiction with the Phillips Curve. Many Keynesian economists, trying to preserve the ideas behind this concept, argued that the Phillips Curve was migrating in a northeastern direction, so that for a fixed unemployment rate inflation is higher.

Phelps Theory:

Phelps theories provided a distinction between short-run and long-run scenarios. To explain the inadequacies of the Phillips Curve he and Friedman developed the Expectation-Augmented Phillips Curve which combines the inflationary expectation and the concept of natural rate of unemployment. They claimed that in the long-run the expected inflation adjust to changes in actual inflation and in the short-run the Philips curve shifts to the right. This means that in the long run there is no inverse relationship between the inflation rate and the unmemployment rate, and the Phillips Curve is a vertical line at the natural rate of unemployment. In the short-run, however, the Phillips Curve shifts to the northeast, as we can see in Figure 2. In the figure, U1 and U2 represent the natural rate of unemployment at two short-run Phillips curves (SRPC) and the vertical line represents the long-run Phillips Curve (LRPC). Later we will explain how the SRPC1 shifts to SRPC2.

Fig. 2. Expectation-Augmented Phillips Curve

How the shift of the SRPC takes place

Friedman and Phelps argue that for every expected inflation rate there is a unique SRPC. When the inflationary expectation is higher, the curve moves northeast, as is indicated in Fig. 2. To explain this idea refer to Fig. 3. Suppose the economy is at inflation rate I1 and at a corresponding natural rate of unemployment U1 (part (A) of Fig. 3). Now suppose that the government attempts to lower the rate of unemployment by increasing money supply. More jobs would be created and the unemployment rate will fall to U2. At this point the inflation rate will increase to I2 in Fig. 3 as the economy (SRPC1) goes from point A to point B. Now, if the inflation rate stays at I2, the workers will ask for an increase in their salary (they have anticipated the inflation rise and they want to maintain their purchasing power). This, in turn, means less workers will be hired (after all the employer will not be able to hire many workers at the new wages), and the new wage (higher than the old wage) becomes the wage that will set the new natural rate (U2). This condition will force SRPC1 to shift to the right (SRPC2) because the employers will stop hiring at the new wages and the economy will adjust back at the old natural rate (U1). But the new rate of inflation correlated to the new natural rate (brought by fiscal interventionist policies) continues at a higher rate (point C in the Figure 3). In other words, it is not possible for the govenment to use expansioninst policies to permanently drive unemployment rate below the natural rate. The result of this will produce higher inflation and a return to higher unemployment rate but with higher inflation.

Fig. 3. How the SRPC shifts northeast

For this revolutionary work, Edmund S. Phelps was awarded the Nobel Prize. Not bad!

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