The 2006 Nobel Prize in Economics has been awarded to Edmund S. Phelps of Columbia University for his contributions to understanding the tradeoff between unemployment and inflation. Dr Phelps overturned the formerly accepted idea that inflation and unemployment are causally related.
In the 1950s and 1960s, policy economists virtually throughout the developed world came to believe that unemployment was influenced by inflation. This belief was based on the observed inverse correlation between the rate of inflation and the rate of unemployment: The higher the observed rate of inflation, the lower the unemployment rate. This relationship became known as the Phillips curve, after A. W. Phillips, the New Zealand economist who wrote the 1958 article that popularized this correlation.
Politicians in the 1950s and 1960s used the relationship to pick an acceptable level of unemployment and inflation. They adjusted taxes, public expenditure and interest rates to pick a desirable spot on the supposed unemployment and inflation trade-off.
Ultimately the relationship was to break down in the early 1970s, but before the facts proved its downfall, it had come under theoretical attack from Edmund Phelps and Milton Friedman in the late 1960s.
Prof Phelps was critical about the purely statistical nature of the Phillips curve, which was not grounded in economic theories of decisions made by people or companies. Nor was it related to any notion of stability in the labour market.
During the 1960s, politicians and policy makers tried to manipulate the perceived Phillips Curve relationship by pushing inflation higher in hopes that unemployment would thereby be reduced. In the event, however, that only set up a spiral of higher prices followed higher unemployment. Thus, the era of stagflation that began in the late 60s and persisted through the 70s.
Edmund Phelps opposed this understanding of the Phillips Curve as simplistic, naïve, and without theoretical foundation.
Phelps challenged this view through a more fundamental analysis of the determination of wages and prices, taking into account problems of information in the economy. Individual agents have incomplete knowledge about the actions of others and must base their decisions on expectations. Phelps formulated the hypothesis of the expectations-augmented Phillips curve, according to which inflation depends on both unemployment and inflation expectations.
As a consequence, the long-run rate of unemployment is not affected by inflation but only determined by the functioning of the labor market. It follows that stabilization policy can only dampen short-term fluctuations in unemployment. Phelps showed how the possibilities of stabilization policy in the future depend on today's policy decisions: low inflation today leads to expectations of low inflation also in the future, thereby facilitating future policy making.
Dr Phelps’s macroeconomic model implies that inflation cannot have a lasting impact on unemployment. Rather, there exists a so-called “natural rate of unemployment” (more accurately called the “non-accelerating inflation rate of unemployment”, or NAIRU). 1976 Nobel-Prize winner Milton Friedman also made important theoretical contributions to the development of the NAIRU concept.
Because the Phillips Curve justified government attempts to manipulate the economy, its invalidation by Phelps and Friedman was a major defeat for Keynesian macroeconomics. For that reason, perhaps, the New York Times seizes on a quote from Dr Phelps lamenting the very model for which he was awarded the Nobel Prize.
Mr. Phelps himself has become less than enchanted by his findings. “The ‘natural unemployment’ rate,” he said, “leaves people with the idea that there is no hope. It is an act of nature that cannot be repealed by man.”
I have to believe that the Times has quoted Dr Phelps out of context, for that statement is simply incorrect as it stands. Although the NAIRU is not altered by overall levels of taxing and spending, it can be influenced by microeconomic labour market policies, such as education and training programs and other incentives facing workers. It has also been shown to be related to unemployment benefits: the more generous the benefits, the higher the NAIRU. Many economists believe that Canada’s more generous benefits help explain why Canada’s unemployment rate is virtually always above that in the United States, indicating that Canada has a higher NAIRU.
UPDATE (11 Oct.): An illustration of the final point: Offer generous unemployment benefits, get higher unemployment
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