Monday, February 26, 2007

Analysis of the Nobel Prize winning macro-economic theory by Edmund S. Phelps


Analysis of the Nobel Prize winning macro-economic theory by Edmund S. Phelps.


The work of Phelps basically deals with unemployment in the economy. He tried to answer some of the basic macro-economic questions that were left unanswered by the classical macro-economists as Keynes. He tried to answer why involuntary unemployment is observed even in the best of times and why a drop of aggregate “effective demand” causes a rise of unemployment.

His award winning theory is called the ‘Intertemporal tradeoffs in macro-economics’. These tradeoffs are between the unemployment and the inflation present in the economy. He directly points out on the irrelevance of the Phillips curve which showed the relation between inflation and unemployment. The thoughts of Phelps on this topic are discussed here within.

Phelps says that low unemployment and low inflation are central goals of any stabilization policy. During the 1950s and 1960s the view of a stable tradeoff between inflation and unemployment was established in the form of called Phillips curve. According to this, the price for reduced unemployment was a one-time increase of the inflation rate. He challenged this view through a more fundamental analysis of the determination of wages and prices, taking into account problems of information in the economy. Individual agents have incomplete knowledge about the actions of others and must base their decisions on expectations. He formulated the hypothesis of the expectations-augmented Phillips curve, according to which inflation depends on both unemployment and inflation expectations.

According to Phelps, unemployment does not only depend on inflation it also depends on the expectation of unemployment. He showed that how low inflation today leads to expectation of low inflation in the future. So using this concept he had put forth a new type of Phillip curve called the expectations augmented Phillip curve. He recognized that inflation does not only depend on unemployment, but also on the expectations of firms and employees about price and wage increases. Phelps put together a new model to describe the relationship between inflation and unemployment, known as the expectations-augmented Phillips curve.
As a consequence, the long-run rate of unemployment is not affected by inflation but only determined by the functioning of the labor market. It follows that stabilization policy can only dampen short-term fluctuations in unemployment. Phelps showed how the possibilities of stabilization policy in the future depend on today's policy decisions: low inflation today leads to expectations of low inflation also in the future, thereby facilitating future policy making.
-fahad jameel

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