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The Phelps Factor

On December 10, Edmund Phelps, my colleague at Columbia University, received the Nobel Prize in economics for 2006. The award was long overdue. While the Nobel Prize committee cited his contributions to macroeconomics, Phelps has made contributions in many areas, including the theory of growth and technological change, optimal taxation, and social justice.

Phelps’ key observation in macroeconomics was that the relationship between inflation and unemployment is affected by expectations, and since expectations themselves are endogenous – they change over time – so, too, will the relationship between unemployment and inflation. If a government attempts to push the unemployment rate too low, inflation will increase, and so, too, will inflationary expectations.

This insight holds two possible policy implications. Some policymakers have concluded from Phelps’ analysis that the unemployment rate cannot be lowered permanently without ever-increasing levels of inflation. Thus, monetary authorities should simply focus on price stability by targeting the rate of unemployment at which inflation does not increase, referred to as the “non-accelerating inflation rate of unemployment” (NAIRU).

But the NAIRU is not immutable. The correct implication, which Phelps repeatedly emphasized, is that governments can implement a variety of policies, particularly structural policies, to allow the economy to operate at a lower level of unemployment.