Tweet
And congrats to Edmund Phelps at Columbia University for his Nobel for Economics!
From the FT...
From the FT...
Nobel prize for economist Phelps
By Chris Giles, Economics Editor
Published: October 9 2006 13:29 | Last updated: October 9 2006 13:29
The 2006 Nobel prize for economics has been awarded to Professor Edmund Phelps of Columbia University for his work in the late 1960s overturning the conventional wisdom on the trade-off between inflation and unemployment.
The Royal Swedish Academy of Sciences said it had awarded the economics prize in memory of Alfred Nobel to Prof Phelps “for his analysis of the intertemporal trade-offs in macroeconomic policy”.
ADVERTISEMENT
It is the second time the academy has awarded the prize to a fierce critic of post-war Keynesian macroeconomic policy. Milton Friedman, the grandfather of monetarism, won the prize in 1976.
After the second world war, practical economists noticed that as unemployment fell in many advanced economies, inflation tended to rise and vice versa. This relationship between inflation and unemployment became known as the “Phillips curve” and seemed to conform with a crude interpretation of the teachings of John Maynard Keynes.
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.
In challenging the naivety of policy based on a simple Phillips curve, Prof Phelps stressed that inflation depended on not only the levels of unemployment, but also how quickly companies and households expected prices and wages to rise.
His reasoning was that for any level of unemployment, if people and companies expected inflation to rise, they would demand higher wages and set prices higher, so the expectations would become a self-fulfilling prophesy.
He said that expectations of price rises tended to go up when unemployment was below an ‘”equilibrium rate”, which can differ between countries, depending on institutions and the strength of the labour market. If unemployment falls below this equilibrium level, inflation tends to rise (as in the standard Phillips curve model) but then expectations of inflation rise accordingly, resulting in no lower unemployment but higher inflation.
Prof Phelps’ model become known as the “expectations augmented Phillips curve” and the work has had profound consequences for economic policy.
The disastrous rise in inflation in the early 1970s was partly a result of policymakers not understanding that the equilibrium unemployment rate had risen as productivity growth fell and the oil crisis hit, so they kept loosening monetary and fiscal policy to lower unemployment below this level, with the consequence of ever higher inflation.
Now, the state of the labour market and expectations of inflation are central to the policymakers’ tool kit. Monetary policy in most countries attempts to stabilise the economy around the best guess of the equilibrium level of unemployment so that expected and actual rates of inflation remain low and stable.
By Chris Giles, Economics Editor
Published: October 9 2006 13:29 | Last updated: October 9 2006 13:29
The 2006 Nobel prize for economics has been awarded to Professor Edmund Phelps of Columbia University for his work in the late 1960s overturning the conventional wisdom on the trade-off between inflation and unemployment.
The Royal Swedish Academy of Sciences said it had awarded the economics prize in memory of Alfred Nobel to Prof Phelps “for his analysis of the intertemporal trade-offs in macroeconomic policy”.
ADVERTISEMENT
It is the second time the academy has awarded the prize to a fierce critic of post-war Keynesian macroeconomic policy. Milton Friedman, the grandfather of monetarism, won the prize in 1976.
After the second world war, practical economists noticed that as unemployment fell in many advanced economies, inflation tended to rise and vice versa. This relationship between inflation and unemployment became known as the “Phillips curve” and seemed to conform with a crude interpretation of the teachings of John Maynard Keynes.
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.
In challenging the naivety of policy based on a simple Phillips curve, Prof Phelps stressed that inflation depended on not only the levels of unemployment, but also how quickly companies and households expected prices and wages to rise.
His reasoning was that for any level of unemployment, if people and companies expected inflation to rise, they would demand higher wages and set prices higher, so the expectations would become a self-fulfilling prophesy.
He said that expectations of price rises tended to go up when unemployment was below an ‘”equilibrium rate”, which can differ between countries, depending on institutions and the strength of the labour market. If unemployment falls below this equilibrium level, inflation tends to rise (as in the standard Phillips curve model) but then expectations of inflation rise accordingly, resulting in no lower unemployment but higher inflation.
Prof Phelps’ model become known as the “expectations augmented Phillips curve” and the work has had profound consequences for economic policy.
The disastrous rise in inflation in the early 1970s was partly a result of policymakers not understanding that the equilibrium unemployment rate had risen as productivity growth fell and the oil crisis hit, so they kept loosening monetary and fiscal policy to lower unemployment below this level, with the consequence of ever higher inflation.
Now, the state of the labour market and expectations of inflation are central to the policymakers’ tool kit. Monetary policy in most countries attempts to stabilise the economy around the best guess of the equilibrium level of unemployment so that expected and actual rates of inflation remain low and stable.
Comment