Information for the Public, The Prize in Economic Sciences 2006. Full employment, stable prices and rapid growth are central goals of economic policy. But policy always faces difficult goal conflicts. How should inflation and unemployment be balanced against each other? What tradeoff should be made between the consumption of current and future generations? Edmund S. Phelps has advanced our understanding of both of these tradeoffs. He has emphasized that not only the issue of savings and capital formation but also the balance between inflation and unemployment are fundamentally issues about the distribution of welfare over time. PhelpsÃÂÃÂ¢ÃÂÃÂÃÂÃÂs analyses have had a profound impact on economic theory as well as on macroeconomic policy.inflation; unemployment

Committee, Nobel Prize

English

Research Papers in Economics

 (4) The Prize in Economic Sciences 2006 • The Royal Swedish Academy of Sciences • www.kva.se
The Prize in Economic Sciences 2006
I n f o r m at I o n  f o r  t h e  p u b l I c
Full employment, stable prices and rapid growth are central goals of economic policy. But policy 
always faces difficult goal conflicts. How should inflation and unemployment be balanced against 
each other? What tradeoff should be made between the consumption of current and future genera-
tions? Edmund S. Phelps has advanced our understanding of both of these tradeoffs. He has empha-
sized that not only the issue of savings and capital formation but also the balance between inflation 
and unemployment are fundamentally issues about the distribution of welfare over time. Phelps’s 
analyses have had a profound impact on economic theory as well as on macroeconomic policy.
Inflation and unemployment
According to the prevailing view during the 960s there existed a stable negative relation-
ship between inflation and unemployment, the so-called Phillips curve. This relationship was 
apparently confirmed by data from several countries. The implication was that there was 
a choice for economic policy between low inflation and low unemployment. By expanding 
demand through fiscal and monetary policy it was possible to reduce unemployment. Accor-
ding to the Phillips curve, this would come at the price of a one-time increase in the rate of 
inflation.
There were several problems associated with this view. The Phillips curve was a purely sta-
tistical relationship. There was no clear link to microeconomic theories about the behavior 
of individual firms and households. There was also no theory about the minimum possible 
unemployment. It was of course generally accepted that the unemployment rate could not 
be reduced to zero, but there was no clear understanding of what level of unemployment was 
compatible with equilibrium in the labor market. 
In the late 960s, Edmund Phelps challenged the earlier view on the relationship between 
inflation and unemployment. He recognized that inflation does not only depend on unemploy-
ment but also on the expectations of firms and employees about price and wage increases. He 
formulated the first model of what has come to be known as the expectations-augmented Phillips 
curve. This says that for a given unemployment rate a one percentage point increase in expec-
ted inflation leads to a one percentage point increase in actual inflation. In setting prices and 
negotiating wages and salaries, firms and employees base their decisions on their beliefs about 
the development of prices and wages in general. This hypothesis has received overwhelming 
support in subsequent empirical research (with the possible proviso that the impact of infla-
tion expectations on actual inflation may be smaller at very low inflation rates).
Phelps’s analysis stood in contrast to the earlier views on the ability of an expansionary fiscal 
and monetary policy to permanently increase employment. Instead, his conclusion was that 
there is no long-run tradeoff between inflation and unemployment, since inflationary expec-
tations will adapt to the actual inflation. In the long run, the economy is bound to approach 
the equilibrium unemployment rate, at which actual and expected inflation coincide. Equilibrium 
unemployment is only determined by the functioning of the labor market. Attempts to per-
manently reduce unemployment below the equilibrium rate will only result in continuously 
increasing inflation. Stabilization policy still has an important role to play in dampening the 
short-run fluctuations in unemployment around its equilibrium level.2 (4) The Prize in Economic Sciences 2006 • The Royal Swedish Academy of Sciences • www.kva.se
Phelps’s contributions highlighted the importance of analyzing how future possibilities of 
reaching the goals of stabilization policy are affected by today’s policy: high inflation today 
means higher inflation expectations in the future, thereby rendering future policy choices 
more difficult. A policy of maintaining low inflation can therefore be regarded as an invest-
ment in low inflation expectations, enabling more favorable combinations of inflation and 
unemployment in the future than would otherwise be available.
Phelps also developed the first model of the determinants of equilibrium unemployment. In 
this model, firms set wages in order to affect the number of employees. The more a firm needs 
to expand its workforce and the lower the rate of market unemployment, the higher the wages 
it will offer. Phelps showed that there exists a unique equilibrium unemployment rate, at 
which the average firm will raise its wages at the same rate as wages are expected to rise on 
average in the economy. The innovative aspect of Phelps’s approach was that it started from 
explicit assumptions about the behavior of individual agents in the labor market. Phelps’s con-
tribution was also the first to integrate the hypothesis of efficiency wages into macroeconomic 
theory. This hypothesis states that it may be in the best interest of a firm to set high wages in 
order to improve workers’ morale, reduce labor turnover and attract better qualified employ-
ees. Such mechanisms may help to raise the level of unemployment in equilibrium. 
Phelps was not alone in criticizing the Phillips curve in the late 960s. Milton Friedman (976 
economics laureate) also emphasized the role of inflation expectations. In contrast to Fried-
man, Phelps emphasized that causation runs from unemployment to (unanticipated) inflation. 
He derived the expectations-augmented Phillips curve from an explicit model of the wage-set-
ting behavior of firms in a labor market in which matching the unemployed with vacant jobs 
is a time-consuming process.
Phelps’s work has fundamentally altered our views on how the macroeconomy operates. The 
theoretical framework that he developed in the late 960s soon proved fruitful in understan-
ding the causes of the increases in both inflation and unemployment that took place during 
the 970s. He also clarified the limitations of macroeconomic policy. As a result, policy is now 
conducted in a radically different fashion from before. One example is that central banks now 
routinely base their interest rate decisions on assessments of the equilibrium unemployment 
rate and the tradeoffs between the effects of policy at different horizons.
Capital formation
Viewing low-inflation policy as an investment in low inflation expectations was natural to 
Phelps against the background of his earlier work on capital formation. There he had asked 
what rate of aggregate capital formation (both in the form of physical capital and human capi-
tal, i.e. education as well as research and development) is desirable. What fraction of natio-
nal income should be consumed now and how much should be invested in order to increase 
the capital stock, thereby boosting future production and consumption? This question is cru-
cial for the distribution of consumption and welfare across generations. In this area as well, 
Phelps’s contributions have opened the doors to later research and had a profound impact on 
the debate over economic policy. (4) The Prize in Economic Sciences 2006 • The Royal Swedish Academy of Sciences • www.kva.se
In one of his first published articles from 96, Phelps derived the so called golden rule of capital 
formation. Taking an inter-generational perspective he posited that the goal is to attain the 
maximum consumption per capita that is sustainable in the long run. The term golden rule 
makes reference to the ethic of reciprocity: “Do unto others as you would have them do unto 
you”. Here the interpretation is that the consumption level should be the same for all gene-
rations. According to the rule, the desirable savings ratio fulfills a simple condition: it should 
equal the ratio of capital income to national income. An alternative statement is that the 
savings rate should be high enough to maintain a capital stock that yields a return (a real rate 
of interest) that is equal to the rate of growth in the economy. Similar conditions had been 
stated before by Maurice Allais (988 economics laureate), among others. But it was Phelps’s 
analysis that had the greatest influence on subsequent research.
Phelps’s original analysis was restricted to comparing long-run situations, presuming that the 
economy was there “from the beginning”. But the process of changing the savings ratio from 
one level to another may create distributional conflicts. If an increase in the savings rate is 
required in order to attain the golden rule, the welfare of future generations will increase 
but the current generation will lose. The reason is that the current generation has to reduce 
its consumption in order to save more, whereas later generations will benefit from a larger 
capital stock allowing them to increase both consumption and saving. However, Phelps later 
demonstrated that there may be situations of dynamic inefficiency, where the capital stock is so 
large that it is possible to increase the welfare of all generations by reducing the savings rate. 
The explanation is simple. By reducing the savings rate, consumption can be increased imme-
diately. If the original savings rate is above the golden-rule level, this reduction also implies a 
long-run gain in consumption. Despite a lower capital stock, and hence lower production, the 
lower savings rate offers scope for more consumption. 
Parents tend to care about the welfare of their offspring. In a contribution from 968 that was 
long before its time, Phelps (jointly with Robert Pollak) concluded that savings can be too 
low if the current generation has a different valuation of its own consumption in relation to 
that of the next generation (their children) than it has of the consumption of the children in 
relation to their grandchildren. Such so-called time-inconsistent preferences may be expres-
sed as “my parents think that I should save more for my children than I think myself”. In 
these circumstances, public measures in order to increase the savings of all generations, e.g. 
through a public pension system, can increase the welfare of all generations. Time-inconsis-
tent preferences, like those analyzed by Phelps and Pollak, have recently attracted a great deal 
of attention in the field of behavioral economics, where insights from psychology have been 
introduced into economic analysis. 
Phelps also analyzed the role of investment in education (human capital) and research and 
development (R&D) in the growth process and shown that the golden rule can be generalized. 
In order to achieve maximum long-run consumption, R&D investments (which raise the tech-
nology level) should also be adjusted to the level where their return is equal to the growth rate 
in the economy. In joint work with Richard Nelson from 966, Phelps emphasized how a better 
educated work force facilitates the dissemination of new technology, thereby making it easier 
for poorer countries to “catch up” with richer countries. This may explain why recent empirical 
research has found that GDP growth appears to depend on the existing stock of human capi-
tal, not just its growth rate. The Nelson-Phelps analysis also offered a possible explanation 
of why the return to education is often high in periods of rapid technological change: during 4 (4) The Prize in Economic Sciences 2006 • The Royal Swedish Academy of Sciences • www.kva.se
such periods a well educated workforce is particularly important for increased productivity. 
Such arguments have been put forth in order to explain why the salaries of highly educated 
employees have increased significantly in the United States (and in many other countries) in 
recent decades, when the IT-revolution has initiated a rapid diffusion of new technology.
......................................................................................................................................................
links and FuRtHeR Reading
Most of Phelps’s articles and books are relatively technical, but he has also written a number of more popular 
texts that can be read by laymen. A good example is his book inflation Policy and unemployment theory (New 
York: Norton; London: Macmillan, 1972) where he discusses inflation and unemployment policy using the 
theories that he developed in the late 1960s.
Another relatively accessible paper is “The origins and further development of the natural rate of unemploy-
ment” published in Rod Cross (ed.) the natural Rate of unemployment, Reflections on 25 Years of the Hypothe-
sis (Cambridge University Press, 1995). 
In the essay “A life in economics” published in Arnold Heertje (ed.), the Makers of Modern economics, vol. II 
(Edward Elgar, 1995) Phelps gives an account of his research career.
Phelps’s article “The golden rule of accumulation: A fable for growthmen”, in which he analyzes the golden 
rule of capital formation is an entertaining classic. It was published in the american economic Review, vol. 51, 
September 1961.
Another classic is the ‘Phelps volume’, the anthology that Phelps published in 1970 under the title Microecono-
mic Foundations of employment and inflation theory (Norton).
LINKS
The address of Edmund Phelps’s homepage at Columbia University, New York, is www.columbia.edu/~esp2
The Academy’s website, www.kva.se, and http://nobelprize.org have more information on this year’s prize, 
including a web-TV broadcast of the press conference and advanced information mainly intended for the 
research community.
Edmund S. Phelps
Dept. of Economics
University of Columbia
International Affairs Building
Room 1004, 10th floor
New York, New York 10027
USA
www.columbia.edu/~esp2
US citizen, born 1933 (73) in Evanston, IL, USA. PhD in economics in 1959 from Yale University, CT, 
USA. McVickar Professor of Political Economy at Columbia University, NY, USA.
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tHe lauReate

Edmund Phelps: Inflation and Unemployment

http://www.nobelprize.org/nobel_prizes/economics/laureates/2006/popular-economicsciences2006.pdf

Edmund Phelps: Inflation and Unemployment

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