[908] Of Phelps and Prize in Economics

As a blog that pretends to know economics, it’s embarrassing for me to not to blog about Edmund Phelps when he was awarded with the Prize in Economics earlier this week. Almost all blogs that love economics are celebrating his achievement. So, today, I want to celebrate his achievement too.

In modern macroeconomics, students learn that there is a trade off between inflation and unemployment. If inflation goes up, unemployment goes down and vice versa. Those who are familiar with economics will know that this refers to the Phillips curve.

The problem with the Phillips curve is that in macroeconomics, in the long run, nominal factor does not affect real factor. Inflation is a nominal factor and so, in the long run, inflation does not affect the real economy. Despite that, the original Phillips curve says that inflation affects real component of the economy.

Phelps added inter-temporal dimension into the Phillips curve. In essence, his research suggests that current expectation of future inflation affects future Phillips curve. This is the expectation-augmented Phillips curve and with that, he solved the nominal-real problem. In simple terms, the Phillips curve could move around.

The new Phillips curve is dynamic and it shows that there’s no trade off between inflation and unemployment in the long run. The new model also able to explain the stagflations of the 1970s and the low unemployment and inflation rates during the 1990s. The old static Phillips curve can’t explain those two historical events.

I learned that in class and he won the Prize in Economics for it. Last year, the winners contributed to the advancement of game theory. And yup, I learned about that in class too.

p/s – economists for full-cost accounting. Yup, among them are Greenspan and Mankiw. Mankiw call this group of economists as the Pigou Club.