The Hindu Business Line : How Phelps tweaked Phillips curve

This year's Nobel for Economics has gone to Edmund S. Phelps. The Nobel Foundation's site http://nobelprize.org informs that the Royal Swedish Academy of Sciences has chosen Phelps for `the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2006.' And that the prize is in recognition of his `analysis of intertemporal tradeoffs in macroeconomic policy.'

Adopting a zero-base approach, let's begin by deconstructing the phrase.

Intertemporal tradeoffs

`Intertemporal' means `occurring across different periods of time,' as Deardorff's Glossary of International Economics defines. "Many economic decisions are intertemporal in the sense that current decisions affect also the choices available in the future," explains www.sfb504.uni-mannheim.de in a useful glossary.

For example, if you save today, you can consume less today, and so current utility declines. Yet your future utility increases because you can consume more in the future! "Intertemporal decisions are characterised by some kind of intertemporal trade-off: If I give up something today, I want to be compensated for the resulting utility loss in the future." The trade-off that was to interest Phelps was inflation vs unemployment.

Both these are topics of relevance to macroeconomics, "the field of economics that studies the behaviour of the aggregate economy," as www.investopedia.com defines. "Macroeconomics examines economy-wide phenomena such as changes in unemployment, national income, rate of growth, gross domestic product, inflation and price levels." In contrast, microeconomics "analyses the market behaviour of individual consumers and firms in an attempt to understand the decision-making process of firms and households."

Natural rate of unemployment

Sveriges Riksbank, after which the prize is named, is `Sweden's central bank, which funded the prize in 1968,' as www.businessweek.com informs. And Phelps, aged 73, is McVickar Professor of Political Economy in the Department of Economics of Columbia University (www.columbia.edu), New York, US. Okay, "What did Phelps do to win the prize?" Michael Mandel asks this question in an October 9-dated article in BusinessWeek, and answers thus: "In the 1960s, along with famed Chicago economist Milton Friedman, Phelps helped create the concept known as the `natural rate of unemployment'."

This metric is "the rate of unemployment where the labour market is in a position of equilibrium," explains www.revisionguru.co.uk. Means? Labour supply = labour demand at a given real wage rate. That is, "all those people willing and able to take paid employment at the going wage rate do so." Labour force refers to `the number of active participants in the labour market'; and it can expand as the real wage rises because there is `a greater incentive to search for paid work and sacrifice leisure.'

As a theme `unemployment' may seem dull, but it has always kept many economists feverishly occupied. On the one side, "the Keynesians, encouraged by the Phillips Curve, assumed that a government could lower the rate of unemployment if it was willing to accept a little more inflation," decodes www.economist.com. And the other side had people like Friedman and Phelps who "argued that this supposed inflation-for-jobs trade-off was in fact a trap".

Meet the Keynesians

Keynesians, as you may know, are not from a planet called Keynes, but the believers in Keynesian economics, a.k.a. Keynesianism and Keynesian Theory. "An economic theory based on the ideas of twentieth century British economist John Maynard Keynes," Wikipedia states. Keynes was of the view that government policies could be used "to promote demand at a macro level, to fight high unemployment and deflation."

No, the effect would only be short-term, said the critics of Keynes, such as Friedman and Phelps. "Governments that tolerated higher inflation in the hope of lowering unemployment would find that joblessness dipped only briefly before returning to its previous level, while inflation would rise and stay high," elaborates `Economics A-Z' on www.economist.com.

Why so? Because `unemployment has an equilibrium or natural rate.' This, one learns, is `the lowest level of unemployment at which inflation will remain stable'; what determines this is not `demand in an economy' but `the structure of the labour market.' Hence the alternative name for this measure, NAIRU, short for `non-accelerating-inflation rate of unemployment'. Unemployment below this `natural' rate, inflation marches up, and vice versa.

The Philips curve

Fine, but what is Phillips curve? Named after A. W. H. Phillips's 1958 study, this was `a milestone in the development of macroeconomics' representing `the relationship between the rate of inflation and the unemployment rate,' writes Kevin D. Hoover on www.econlib.org. "When unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly."

Phillips curve became popular as a recipe of `policy trade-offs.' Hoover gives an example: "With an unemployment rate of 6.5 per cent, the government might stimulate the economy to lower unemployment to 5.5 per cent," by incurring a cost, `in terms of higher inflation, of less than 0.5 percentage point.'

Phelps and Friedman independently challenged this view. "They argued that well-informed, rational employers and workers would pay attention only to real wages, that is, the inflation-adjusted purchasing power of money wages," as reads a snatch from The Concise Encyclopedia of Economics in the Library of Economics' site.

"Individual agents have incomplete knowledge about the actions of others and must base their decisions on expectations. Phelps formulated the hypothesis of the expectations-augmented Phillips curve, according to which inflation depends on both unemployment and inflation expectations," explains http://nobelprize.org in a press release dated October 9.

Influenced by Phelps' work, central bankers are said to be routinely basing their interest rate decisions `on assessments of the equilibrium unemployment rate and the tradeoffs between the effects of policy at different horizons'.

There is more `gold' to mine in Phelps's work. About that, later.

ZeroBase@TheHindu.co.in

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