The Hindu Business Line : Author of the `island parable' and other Golden Rules

Economic policy-making is the art of balancing, or making trade-offs. How should inflation and unemployment be balanced against each other? What trade-off should be made between the consumption of current and future generations? Policy-makers face these difficult choices constantly. A measure of help comes from Columbia University's Edmund S. Phelps, who offers insights into the relation between short- and long-run effects of economic policy. His analysis of "intertemporal tradeoffs in macroeconomic policy" has won him the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2006, or simply the Economics Nobel.

The 73-year-old Edmund Phelps, who joined the Department of Economics at Columbia in 1971 after several years at Pennsylvania and earlier Yale, is best known for introducing in the late 1960s an expectations-based microeconomics into the theory of employment determination and price-wage dynamics. Keynes's great work of the 1930s had left unexplained why involuntary unemployment happens even in the best of times and why a drop of aggregate "effective demand" causes a rise of unemployment — and not a prompt fall of money wages and prices by just enough to forestall a fall of employment?

Wage-labour equilibrium

In a 1969 paper, Dr Phelps sketched an economy of widely separated `islands' in which workers have to decide whether to accept the local market wage or to move on. Even in an equilibrium scenario, workers on an island with an appreciably inferior wage will get on the boat to try another island, suffering voluntary unemployment during their search.

The main discovery from these models was the potential for disequilibrium and its effects on economic activity. Errors in wage or price expectations would disturb the volume of unemployment. If, in the labour turnover model, each firm deciding its next wage, say, underestimates the wage being set at the other firms, that is, the actual wage exceeds the expected wage, the error reduces the firms' expected turnover and hence their expected costs, thus encouraging them to pay less and hire more, which drives down unemployment.

If, in the islands model, the average wage exceeds what workers expect it is, the underestimate prompts some workers to accept a job rather than go on searching, so, again, unemployment drops. In the same spirit, a 1967 paper supposed that an underestimate by each firm of the price being set by the others would encourage increases in output supply and labour demand, raising employment; a 1970 paper introducing the "customer market," co-authored with Sidney Winter, supplied a basis for this idea.

Keynesian puzzle answered

From all this, an answer to the puzzle of Keynes emerged: An unperceived rise in "effective demand," in driving up the average money wage and the price level, would reduce unemployment if the average firm (or island) did not know or imagine that the general price and wage level had increased by as much as its own - that is, if the actual price or wage inflation exceeded the expected. A persistent over-estimation of upcoming money wages and prices could cause a protracted depression.

According to the prevailing view during the 1960s, there existed a stable negative relationship between inflation and unemployment, the so-called Phillips curve. The implication was that there was a choice for economic policy between low inflation and low unemployment. By expanding demand through fiscal and monetary policy it was possible to reduce unemployment. Dr Phelps challenged the earlier view on the relationship between inflation and unemployment. He recognised that inflation does not only depend on unemployment but also on the expectations of firms and employees about price and wage increases.

Dr Phelps's conclusion was that there is no long-run trade-off between inflation and unemployment, since inflationary expectations will adapt to the actual inflation. In the long run, the economy is bound to approach the equilibrium unemployment rate, at which actual and expected inflation coincide. Equilibrium unemployment is only determined by the functioning of the labour market. Attempts to permanently reduce unemployment below the equilibrium rate will only result in continuously

increasing inflation. Stabilisation policy still has an important role to play in dampening the short-run fluctuations in unemployment around its equilibrium level.

Milton Friedman (1976 economics laureate) also emphasised the role of inflation expectations. In contrast to Friedman, Dr Phelps emphasised that causation runs from unemployment to (unanticipated) inflation.

Dr Phelps spent much of the 1970s replying to a further development from other quarters: To theoretical demonstrations that a departure from the current equilibrium path would be merely momentary if every economic actor had so-called rational expectations. (When all the "news" arrives at month's end, prices and wages would jump precisely to regain equilibrium.) In frequently collaborative research at Columbia in the 1970s he argued that if most wage and price setting is non-synchronous, such a deviation would take time to die out even if expectations were rational. This work helped start what came to be known as New Keynesian macroeconomics.

While these views won support among macroeconomics experts, the 1980s were testing times. The decade saw a major slump in Europe with no evidence of unexpected disinflation or deflation; the latter half of the 1990s brought a strong boom to the US economy and northern Europe without evidence of unexpected inflation — all contrary to the simple models. In response, Dr Phelps began in the late 1980s to develop a theory of the equilibrium path itself — a theory of the determinants of the natural unemployment rate.

Capital formation

Dr Phelps derived the so-called golden rule of capital formation. Taking an inter-generational perspective he posited that the goal is to attain the maximum consumption per capita that is sustainable in the long run. The term golden rule makes reference to the ethic of reciprocity: "Do unto others as you would have them do unto you". Here the interpretation is that the consumption level should be the same for all generations. According to the rule, the desirable savings ratio fulfils a simple condition: It should equal the ratio of capital income to national income.

Dr Phelps also analysed the role of investment in education (human capital) and research and development (R&D) in the growth process and showed that the golden rule can be generalised. In order to achieve maximum long-run consumption, R&D investments (which raise the technology level) should also be adjusted to the level where their return is equal to the growth rate in the economy. In a joint work with Richard Nelson, Dr Phelps emphasized how a better educated work force facilitates the dissemination of new technology, thereby making it easier for poorer countries to "catch up" with richer countries.

Author of 17 books and 79 papers, Dr Phelps will receive 10 million kronor ($1.4 million) prize on December 10, the anniversary of the death of Alfred Nobel, the founder of the Prizes. Last year's winners were Robert J. Aumann, a citizen of Israel and the United States, and American Thomas C. Schelling, for their work in game-theory analysis.

Sourced from nobelprize.org and columbia.edu.

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