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HIKES AND CURVES
- Why Edmund Phelps got the Nobel Prize in economics this year

Many economics departments in north America run sweepstakes in the month of October. Faculty members and graduate students contribute a dollar or two and bet on who is going to win the Nobel Prize in economics. The lucky few who happen to guess right share the jackpot. Perhaps the Royal Swedish Academy disapproves of gambling because, in most years, there have been very few winners. The ‘hot favourites’ very seldom win the prize.

This year has been no exception to this general rule. The Nobel Prize in economics has been awarded to Edmund Phelps of Columbia University “for his analysis of intertemporal tradeoffs in macroeconomic policy”. It is unlikely that too many people bet on Phelps. This is not because his contributions to economic theory have been unimportant. However, most of his major contributions were several decades ago, in the Sixties and Seventies, and he had receded from the mental radar of most economists.

Professor Phelps is best known for his work on the “Phillips curve”, named after A.W.H. Phillips, whose study of the relationship between the rate of unemployment and inflation represented a milestone in the development of macroeconomics. Phillips discovered an inverse relationship between the rate of wage inflation and the rate of unemployment in the United Kingdom between 1861 and 1957. Since the prices charged by companies are obviously related to the wages they pay their employees, the rate of wage inflation is related to the general price inflation. So economists also used Phillips curves to represent the relationship between inflation and unemployment.

Although the original Phillips curve was an empirical relationship without any explicit theoretical defence, there was some seemingly plausible explanation for the observed relationship. When the rate of unemployment is low, the labour market is tight and there are very few additional employees looking for work. So firms have to offer higher wages to attract new labourers. Conversely, when the unemployment rate is high, the labour market is slack and so there is very little pressure to increase wages.

This relatively simple relationship seemed to offer a very powerful policy prescription. It appeared that governments could actually choose the optimal mix of rates of unemployment and inflation. For instance, expansionary monetary and fiscal policies could be used to reduce the unemployment rate, the only cost being a one-time increase in the rate of inflation.

Ed Phelps (and simultaneously another Nobel laureate, Milton Friedman) destroyed this neat and convenient relationship between unemployment and inflation. Phelps argued that the traditional explanation of the Phillips curve modelled workers as being too naïve. The natural reaction of firms to a wage hike is to pass on the increase in costs to consumers by raising prices. But well-informed and rational workers should be able to foresee the increase in prices. Moreover, they should also base their decisions in the labour market not on money wages, but on “real” wages, that is the money wages adjusted for the price level.

Which means workers will adjust the money wages by the expected rate of inflation. Phelps argued that real wages would adjust so as to equate the demand and supply of labour and so the unemployment rate would be the level associated with that rate of real wage. The important policy implication of this analysis is that governments cannot choose a permanent trade-off between the rates of unemployment and inflation. Phelps’s analysis has made the so-called expectations-augmented Phillips curve a fundamental concept in macroeconomics.

An important implication of the work of Phelps and Friedman was that, at some level, unemployment was an equilibrium phenomenon, and not simply a transient or temporary occurrence. This was in sharp contrast to the theme in Keynes’s great work of the Thirties, which was still the dominant intellectual force in macroeconomics in the Sixties. A major shortcoming of Keynesian macroeconomics was that it did not have any satisfactory theory of this kind of “involuntary” unemployment.

Phelps was one of the first economists to formulate a theory of equilibrium involuntary unemployment. In a paper written in 1968, Phelps specified a framework where the firms set wages in order to influence the number of workers on their payrolls. Firms realize that employee turnover is costly — for instance, new employees have to be trained. So they are willing to incur additional wage costs so as to induce workers to remain with their present employers. Hence, on the equilibrium path, all firms offer ‘incentive’ wages, which are perhaps higher than the market-clearing wage. An unpleasant consequence of the higher level of wages is that the total number of jobs on offer is reduced, so that there are unemployed workers seeking employment. Unfortunately, no firm wants to reduce the wage rate and hire workers from this pool of unemployed workers because of the additional training costs that would be incurred.

Apart from his work on the Phillips curve, Phelps has also written several extremely influential papers on various issues related to long-run growth and considerations of intergenerational equity. A classic paper is his work on the optimal rate of aggregate capital formation. If the current generation cares only about its own level of consumption, then it should not save anything for future generations. This policy would be disastrous for future generations since there would be no capital stock to enhance future output.

The most equitable solution is to choose a level of savings which will ensure that future generations can avail themselves of the same level of per capita consumption as the current generation. Phelps termed this the “Golden Rule” of capital accumulation — a reference to the old Biblical adage of “do unto others as you would have them do unto you” — and derived conditions for the Golden Rule growth.

A natural corollary of his interest in long-run growth resulted in work on what has come to be called time-inconsistent preferences. A tradition in long-run growth theory was an assumption which essentially meant that parents’ valuation of their own consumption vis-à-vis their children’s consumption was exactly the same as their relative valuation of their children’s consumption vis-à-vis their grandchildren’s consumption. In joint work with Robert Pollack, Phelps showed that the savings rate can be suboptimal if this assumption is violated. Although this paper was written far back in 1968, the implications of time inconsistency on policies related to a variety of issues such as social security continue to be an active area of research even today.

Of course, quite unlike his subsequent work on the Phillips curve and time inconsistency, several of his papers on long-run growth have been of little policy relevance. This is true even of his classic paper on the Golden Rule. Nevertheless, the area of optimal growth theory, pioneered as early as 1930 by Frank Ramsey, remained a ‘hot’ topic of research for many decades. Several leading theoretical economists, including some who subsequently went on to win the Nobel Prize, worked in this area. Phelps’s own work certainly ranked with the best in this field. It has certainly stood the test of time, and much of it is widely cited even today. The Nobel Prize has been a just reward.

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