On Oct. 9, Edmund Phelps of Columbia University won the Nobel Prize in Economics for his lifetime of work, dealing primarily with macroeconomic issues. Phelps' most seminal contribution to the field of economics involved debunking the notion that there was a direct negative relationship between inflation and the level of unemployment.
This misunderstanding, which Phelps helped to correct, occurred in the 1960s, when there was almost a perfect negative and linear relationship between inflation and unemployment. As inflation went up during those years, unemployment invariably decreased, and vice versa.
After seeing this relationship hold for several years, many economists began to surmise that unemployment could be driven down to nothing if a central bank such as the U.S. Federal Reserve simply increased the economy's money supply by lowering interest rates. This perceived negative relationship between inflation and unemployment was dubbed the Phillips curve, after A.W. Phillips, a New Zealand economist and primary proponent of the theory.
Phelps, on the other hand, thought no such relationship existed between anticipated inflation and unemployment. He argued that only unanticipated inflation could cause a change in unemployment.
For instance, if everyone in an economy expected inflation to double from one year to the next, the level of unemployment wouldn't change at all. But an unexpected doubling of inflation, due to an immediate drastic change in oil prices or an unexpectedly large change in interest rates, for example, would definitely have an effect on unemployment and the rest of the economy.
For several years after his published journal articles, there was a great debate over whether Phelps' or Phillips' theory on the inflation/employment trade-off was correct. Then, in the 1970s, the Federal Reserve and other central banks throughout the world enacted stimulatory monetary policies which would have caused inflation -- but also increased employment, if Phillips' theory was correct. Unfortunately, these policies triggered a huge increase in inflation, but no commensurate rise in employment, because the central banks' policy announcements ensured that everyone knew ahead of time what they were going to do. The natural experiment clearly showed Phelps' theory to be superior to Phillips', and thus has influenced the policies of central banks throughout the world ever since.
Phelps' improved theory about the relationship between inflation and unemployment was called the expectations-augmented Phillips curve. His theory taught central bankers that monetary policies, like changing interest rates, had to be unexpected to have any sort of real and sustained effects on the macro economy. This explains why the Federal Reserve hates to announce its interest-rate policies ahead of time. Also, whenever asked in an interview or congressional hearing, the Fed chairman always remains coy about his policy agenda. If everyone knew what the Fed was about to do, it would then lose the surprise effect of its policies.
There is certainly more to Phelps' body of work than just his inflation-employment theory. Phelps also contributed greatly to a model of long-run economic growth named the Solow Model, which has been the primary focus of research for many macroeconomists to this date. Without a doubt, though, Phelps' most important contribution to the field, and the everyday life for billions of people, was his work on understanding the relationship (or lack of one) between inflation and employment.
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Fool contributor Brian Lawler does not own shares of any company mentioned in this article. The Fool has a disclosure policy.
