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2006 Nobel Prize Winner - Edmund Phelps

Edmund Phelps Image courtesy of the Nobel Foundation. Edmund Phelps is McVickar Professor of Political Economy at Columbia University in New York. He has won the Nobel Prize for his work on macroeconomics and for developing understanding of the relationship between inflation and unemployment. The key area of the research for which he was recognised was in investigating the trade-off between inflation and unemployment and between future and current consumption. His work has fed through into macroeconomic policy-making and whilst you may not have heard his name before, you will have heard of the issues with which he has become recognised.

Expectations

One of the key areas Phelps identified in macroeconomic policy is the role of expectations. Phelps pointed out that unlike traditional market theory, where prices and wages adjust quickly, in reality wages (for example) tend to be adjusted infrequently - usually at an annual pay round. When this occurs, workers or their representatives and employers will not only take into consideration current inflation but also what expected or anticipated inflation would be. The Philips Curve pointed to a relationship between inflation and unemployment. Phelps took the analysis of the Philips Curve further and developed the 'expectations- augmented Philips Curve'. This suggested that inflation expectations in a current time period would have an effect on the future trade-off between inflation and unemployment.

What this work did was to cast doubt on the ability of Keynesian demand-management policies to deliver long-term stability in macroeconomic policy. What Keynesian policy suggested was that if the economy was operating at less than full employment, inflation would be unaffected by increases in aggregate demand. Changes in aggregate demand could occur through changes in either fiscal policy (changes in government tax and spending decisions) or monetary policy (changing the money supply either through physical measures (such as printing more money) or through changing the price of money - the interest rate).

Keynesian demand management policy could be likened to a system of levers, which have to be moved to achieve the desired outcome. If unemployment was too high, a lever that increased aggregate demand could be moved to help bring down that unemployment. If inflation was too high, reversing the levers to slow the economy down would bring inflation back into line. The publication of the work by Professor A.W. Phillips in 1958 changed this perception to a large extent. He asserted that there was a stable trade-off between inflation and unemployment. Effectively, what this said was that employment could only be increased in the long run at the expense of higher inflation. The Philips Curve is still a part of most economics courses but has been subject to a number of criticisms.

Keynesian demand management - the government would have to be skilled at pulling the right levers at the right time to create long-term stability. In so doing, it may have changed expectations almost without knowing. Copyright: Dan Edwards, from stock.xchng.

Much of this analysis does depend on how we define 'unemployment'. In any economy, it is accepted that there will always be some form of unemployment. Full employment does not mean that everybody who wants a job has one. At so-called 'full employment', there would still be some frictional unemployment - people who register as unemployed whilst between jobs. What determined the level of this frictional unemployment was not something that was well understood.

Phelps spent some time, in the light of some of these problems, attempting to develop a model that might help improve the understanding of how firms set both wages and prices. In this model, he outlined the difference between anticipated and unanticipated inflation. In so doing, he pointed out that it was not simply inflation that was linked to unemployment but the difference between expected and unexpected inflation. This implied that there was no long-run trade-off between inflation and unemployment. In the long run, the Philips Curve would be vertical at an unemployment rate that would be the equilibrium unemployment rate. This is the point where the demand for labour and the supply of labour would be the same at a given wage rate. The number of people out of work at this wage rate would be the equilibrium unemployment rate.

To reduce the rate of unemployment, Keynesian demand management policies would suggest increasing aggregate demand through expansionary fiscal policies. If unemployment is below the equilibrium rate then attempts to increase employment will generate inflation. From this point, Phelps was able to analyse the macroeconomic policies that could be used when there was a short-run but no long-run trade-off between inflation and unemployment. The basis of the analysis rested on a formula that stated that actual inflation is dependent on unemployment and the expected rate of inflation. The prediction implied by this theory suggested that at any given level of unemployment, a one percent increase in expected inflation would bring about a one percent increase in actual inflation.

Expectations about future price movements influence individuals' behaviour. The longer term trade-off between inflation and unemployment was a feature of the work of Phelps - so-called intertemporal trade-offs. Copyright: Biz/ed team.

Adaptive Expectations

This can be seen through the use of a very simple example. Assume expected inflation is currently 4% and unemployment 3%: the actual rate of inflation would be 7%. If expectations of inflation were to rise by, say, 2% and unemployment stayed constant at 3%, then actual inflation would rise to 9%. If anticipated and actual inflation are the same, then the equilibrium rate of unemployment can be determined. Expectations of future inflation might be based on what has happened to inflation in the recent past. This is termed adaptive expectations.

What Phelps' analysis implied was that demand management policy should be focused on finding appropriate levels of unemployment and inflation over a period of time. This contrasted with the notion of trying to achieve a particular combination of inflation and unemployment and inflation at a point in time. If a government attempted to reduce unemployment and higher inflation was the result, this would raise inflationary expectations for the future. This would then impact on the future trade-off between inflation and unemployment.

Edmund Phelps - Nobel Prize winner.

This is referred to as an intertemporal trade-off - it is to do with different periods of time. Many governments (and central banks) now focus on these intertemporal trade-offs. Short-run changes in economic activity are balanced against the strategy to maintain inflation targets in the future. Recent statements by the Bank of England reveal how they are looking beyond the short-term volatility in inflation and economic activity in the UK to the inflation prospects for the medium term. They understand that increases in interest rates are not going to have a full effect for possibly 18 months to 2 years. Inflation in the UK may have risen above the 3% level in early 2007 but the Bank are not panicking because they are looking ahead at the prospects for inflation in the medium term, not the next few months.

Equally, the comments made by the Governor of the Bank of England on regular occasions stating their commitment to maintaining inflation at the target level is partly an acceptance of Phelps' intertemporal trade-off model. If the inflation target can be maintained, this will represent an investment in low inflation expectations in the future. This, in turn, will enable the Bank to generate a more favourable inflation-unemployment trade-off on the future.

The Bank of England in the City of London - many of the decisions made by the Monetary Policy Committee have their grounding in Phelps' work - he has helped inform monetary policy throughout the western world. Copyright: Biz/ed team.

Phelps and Microeconomics

You can be forgiven for thinking that economics is two distinct parts - microeconomics and macroeconomics. Some introductory courses on economics might give the impression that there is really no connection between the two. An increasing number of economists, however, are now looking at how microeconomic analysis can inform macroeconomic policy and understanding. Phelps was one of those to do this: he looked at the behaviour of individuals to help build an understanding of wage-setting behaviour.

Phelps observed that labour markets are essentially imperfect. Firms are able to set wages as a result of temporary monopsony power - i.e. they are the sole buyer of labour at that time. Workers and firms form the market - firms are offering jobs, employees are looking for jobs and the wage rate, to an extent, links these two agents together. A firm can increase its wage and in so doing, reduce the incentive by workers to leave and find other work. It also increases the likelihood of attracting more and better quality employees. This is because the wage rate will be higher relative to other firms in the same market.

Many workers have only limited power in the market - in the short term, the employer holds all the cards! Copyright: Cris DeRaud, from stock.xchng.

If unemployment is rising, the firm is able to reduce its relative wage and still maintain its desired hiring rate - i.e. get the employees it requires. If employment is rising, on the other hand, then the firm will need to increase its relative wage rate. From this analysis, Phelps showed that there would be a unique rate of unemployment associated with a relative wage equal to the expected rate of increase in average wages.

Phelps also introduced the idea of efficiency wages. In this model, Phelps suggested that a firm could set its wages higher that the market level. They would do this to improve motivation and reduce the incidence of staff turnover. In so doing it would have a more effective and efficient pool of job applicants to choose from and keep in the longer term.

Whilst accepting that the long-run Philips Curve was vertical, Phelps argued that there were situations when it could be negatively sloping. This, he suggested, tended to be at lower rates of inflation. Lower rates of inflation might be associated with periods of slower economic growth, possibly caused by demand-side shocks to the economy. Those firms hit hardest by these demand-side shocks might attempt to reduce the rate of wage increases. This will be resisted by workers. In this situation, the reduction in expected wages will not feed through into a reduction in actual wage increases, but unemployment would be likely to rise.

Price Setting

In addition to using micro foundations to analyse wage setting behaviour, Phelps did the same with price-setting behaviour by firms. Phelps and a colleague, Sidney Winter, argued that price need not be reflective of short-term variations in marginal cost. Assume firms are producing a homogenous good: despite this, they do have some short-term monopoly power because buyers do not have perfect information about prices across all sellers. As a result, the firm can raise prices in the short run and face a relatively inelastic demand for its product. If, however, it chooses to keep its price higher, it will eventually lose customers. The trade-off, therefore, is in exploiting short-run market power against long-run loss of customers and impact on profit as a result of maintaining a high price.

A flower seller - do consumers know the prices of every flower seller in the area? Probably not. This gives businesses a degree of monopoly power - but for how long? Copyright: Biz/ed team.

The macro result is that if firms do exploit this short-term market power, price will tend to be higher than marginal cost, but lower than price would be under a monopoly. One of the important macro consequences of this analysis is that output might rise despite prices falling in relation to the nominal wage rate. This real product wage is the ratio between the wage and product price. It is now accepted that changes in business activity lead to changes in the relationship between prices and marginal costs.

Further Research

Phelps' work in the 1960s has continued throughout the latter part of the 20th Century. One result of this work was the idea of hysteresis in unemployment. Hysteresis refers to the extent to which something is affected by an outside force. It does not react immediately to the force and, when it does, may not return to its original state. In unemployment it is the idea that if a worker loses their job they may, if they remain unemployed for a while, lose skill and motivation and as a result, remain long-term unemployed. If this is repeated across the country, some unemployment could turn out to be irreversible - at least in the short to medium term. The reverse of this situation is also possible - long-term unemployment could be favourably reduced as a result of the skills and work experience that employees gain, meaning they are less likely to be out of work for any lengthy period - they are more attractive to employees.

If an individual has been out of work for some time, it may be more difficult to get an employer to take them on again - they may lose skills and motivation to seek out new jobs and this could be irreversible. Copyright: Jake Levin, from stock.xchng.

Such an analysis is relevant to the problems which faced Europe during the 1990s when unemployment remained stubbornly high and persistent. Also, the Labour government in the UK of the late 1990s and early 2000s introduced policies to try to get people off benefits and into work - not only as a means of reducing unemployment but to make people more employable in the longer term.

Phelps and Savings and Capital Accumulation

There as been a great deal of research by Phelps into the role of savings and capital accumulation in the process of growth. Much of his work has rested on what has been termed the 'golden rule' related to the most desirable long-run savings rate. He suggested that the savings rate (the proportion of national income set aside from current consumption) should be equal to the share of capital in national income. This, he suggested, was the same as stating that the return on capital should be the same as the growth rate of output.

This is linked to the benefits to future generations of increases in savings against the trade-off of increased consumption in the present. This, in turn, is related to the concept of dynamic inefficiency. Dynamic inefficiency can be observed if savings could be changed to increase consumption at some point in time without lowering it at another point in time. In such a case, capital accumulation has been too high and would be a market failure.

If the savings rate increased and this increased the long-run capital stock, current generations would have to sacrifice current consumption. Future generations would benefit from their sacrifice but current generations would be worse off. Equally, if the savings rate fell then current generations would see consumption increase. It will then take some time before the capital stock begins to adjust downwards with the subsequent effect on production. If, however, this capital stock is above the golden rule level, the drop in savings will not have the effect of reducing consumption in the future as much and might even increase it. Savings rates higher than the golden rule, therefore, are not beneficial for any generation.

The savings decisions of current generations have an effect on capital stock that will, in turn, have an effect on the welfare of future generations. Copyright: Marcelo Moura, from stock.xchng.

The savings decisions of different generations can be seen in the context of game theory, specifically a non-cooperative game between these generations. Savings, however, is not the only factor in growth that needs to be considered. The stock of human capital is also important. A well educated and skilled workforce would be in a better position to be able to adopt new technology, which contributes more effectively to growth. Output growth, therefore, is more related to the stock of human capital than the rate of growth itself. One of the implications of this is that governments should subsidise education and training.

Phelps's Contribution

Phelps' work has had a major impact on macroeconomic policy and has also influenced the direction of macroeconomic research. He has contributed to our understanding of the relationships between inflation and unemployment as well as capital accumulation, savings and growth. The fundamental framework of this understanding has been in intertemporal trade-offs. The setting of both monetary and fiscal policy has been informed by his work and has helped to clarify our understanding of these major features of economic policy-making.