Phelps takes on Phillips, prompts shift away from prevailing theory

During the 1950s and 1960s, the prevailing economic theory held that central banks could calculate the impact of pursuing their twin goals of low inflation and low unemployment by using the so-called Phillips curve.

To dampen inflation, central banks deliberately slow the economy with higher interest rates and other restrictive policies. They fight joblessness by lowering rates.

The Phillips curve provides a way of measuring the financial tradeoff between inflation and unemployment. It also suggests that central banks should eventually be able to drive unemployment down permanently, simply by making savvy use of financial policies.

However, economist Edmund Phelps — winner of the 2006 Nobel Prize in Economics — disagreed. He argued that a long-term natural rate of unemployment exists, one established by the labor market itself.

As a result, he contended, using economic policy to move joblessness below its equilibrium level works only in the short term.

Longer term, workers' expectations eventually bring real wages back to the unique level the labor marketplace will support. To reflect that reality, Phelps proposed a more complicated model he called the "expectations-augmented Phillips curve," which is still widely employed in economics.

That contribution "radically changed our perception of the interaction between inflation and unemployment," noted the Nobel academy, in awarding the honor to Phelps.