You Might Have Him To Thank for Your Job

By Nell Henderson
Washington Post Staff Writer
Tuesday, October 10, 2006

Columbia University professor Edmund S. Phelps won the Nobel Prize in economics yesterday for his work explaining the relationship between inflation and unemployment, producing theories that helped revolutionize the way the Federal Reserve and other central banks conduct interest-rate policy.

In a series of papers in the late 1960s and early 1970s, Phelps, 73, challenged the prevailing belief that policymakers could lower the nation's long-term unemployment rate by accepting higher inflation.

That misguided notion contributed ruinously to Federal Reserve policies of the 1970s, which allowed easy credit to fan inflation to double-digit levels. The result was high inflation and high unemployment, a combination that came to be called stagflation.

Today, some Americans can probably thank Phelps for their jobs. His work is one key reason Fed policymakers now seek to achieve both low unemployment and low inflation, no longer believing they have to choose between them. That strategy has largely worked for the last 15 years.

The Royal Swedish Academy of Sciences announced the prize yesterday in Stockholm, saying Phelps's theories "radically changed our perception of the interaction between inflation and unemployment" and helped explain the abysmal economy of the 1970s.

"He's one of the people who's had some really long-lasting ideas," said Thomas C. Schelling of the University of Maryland, who won the economics Nobel last year and who taught Phelps at Yale University in the late 1950s. "He has had ideas other people didn't have, and maybe no one else would have had."

Alan S. Blinder, former vice chairman of the Fed, said Phelps's insights, together with related work by Nobel Prize-winning economist Milton Friedman, are "absolutely central and fundamental to the way" the Fed and most other central banks adjust interest rates to guide economic growth and control inflation.

Phelps's work challenged an accepted economic model known as the Phillips curve, named after an economist from New Zealand, A.W. Phillips. It depicted a long-term trade-off between inflation and unemployment, and it implied that policymakers could permanently reduce unemployment if they were willing to accept a higher level of inflation.

Phelps acknowledged a short-term relationship, as when high joblessness lowers demand for goods and services, making it hard for companies to raise prices, or when low unemployment boosts demand and gives businesses more pricing power. But Phelps added that inflation also depends on companies' and consumers' expectations of future price increases. People tend to expect inflation to continue at about the current pace, and they often act in ways that make those expectations self-fulfilling, as occurred during the 1970s when price increases and inflationary expectations soared.

The original Phillips curve failed to explain the experiences of the 1970s, when inflation and unemployment were high, and the late 1990s, when inflation and unemployment were low.

Ultimately, Phelps found, there is no trade-off over the long term, which the Swedish Academy called "one of the most influential ideas in macroeconomics over the past 50 years."

Phelps developed a revised model, called the expectations-augmented Phillips curve. This model is widely used by Fed economists and other central bankers to determine the economy's short-term, natural rate of unemployment. When joblessness is below that level, inflation pressures intensify; when unemployment is above that level, the reverse occurs.

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