Phelps (2006): Why You Can't Buy Low Unemployment with High Inflation Forever

The Tradeoff That Wasn’t

In the 1960s, macroeconomics had a comforting story: governments could choose their preferred combination of inflation and unemployment. Want less unemployment? Just accept a bit more inflation. The Phillips curve — an observed inverse relationship between inflation and unemployment — seemed to offer policymakers a permanent menu of options.

Edmund Phelps blew this up. He showed that the tradeoff is an illusion — it works temporarily, but trying to exploit it permanently leads to ever-accelerating inflation with no lasting reduction in unemployment. This insight, developed independently but along similar lines by Milton Friedman, transformed macroeconomic theory and policy.

The Expectations-Augmented Phillips Curve

The original Phillips curve said: low unemployment causes high inflation, and vice versa. Phelps asked a devastating question: what happens when people start expecting inflation?

The logic:

• Suppose the government stimulates the economy to push unemployment below its “natural” level
• Initially, this works — firms hire more workers, output rises, and inflation increases
• But workers and firms aren’t stupid. They notice prices rising and adjust their expectations. Workers demand higher wages to compensate for expected inflation. Firms raise prices to cover higher wage costs
• Now the same level of unemployment produces higher inflation than before — because expected inflation has risen
• To keep unemployment low, the government must create even more inflation — more than people expect. But expectations adjust again, requiring still more inflation
• The result: accelerating inflation with unemployment eventually returning to its natural rate

This is the expectations-augmented Phillips curve: the short-run tradeoff between inflation and unemployment depends on the gap between actual and expected inflation. In the long run, when expectations catch up to reality, there is no tradeoff at all. The long-run Phillips curve is vertical at the natural rate of unemployment.

The Natural Rate of Unemployment

Phelps introduced the concept of the natural rate of unemployment — the unemployment rate that prevails when inflation is stable (neither accelerating nor decelerating). This isn’t zero, because some unemployment is structural:

• Workers searching for better jobs (frictional unemployment)
• Mismatches between workers’ skills and available jobs (structural unemployment)
• Wage rigidities from unions, minimum wages, or efficiency wage considerations

The natural rate isn’t “natural” in the sense of being optimal or unchangeable — it depends on labor market institutions, regulations, and policies. But it cannot be permanently reduced by monetary or fiscal stimulus. Attempts to push unemployment below the natural rate through demand management only produce inflation.

This had profound policy implications:

• Central banks cannot target unemployment directly — they can only control inflation in the long run
• The stagflation of the 1970s — simultaneous high inflation and high unemployment — was exactly what Phelps’s theory predicted would happen when governments tried to exploit the Phillips curve
• Credibility matters — if people expect the central bank to tolerate inflation, the short-run tradeoff worsens. If they trust the bank to fight inflation, the tradeoff improves

The Golden Rule of Capital Accumulation

Before his work on inflation and unemployment, Phelps made a fundamental contribution to growth theory. He asked: how much should a society save?

The golden rule of capital accumulation (1961): there is an optimal savings rate that maximizes consumption per person in the long run. Save too little, and the economy has too little capital to produce efficiently. Save too much, and people sacrifice current consumption for capital that yields diminishing returns.

The golden rule savings rate is where the marginal product of capital equals the rate of economic growth. This elegant result provided a benchmark for evaluating whether economies are saving too much or too little — and influenced debates about pension systems, public investment, and intergenerational fairness.

Microeconomic Foundations of Unemployment

Phelps didn’t just describe the natural rate — he explained it from the ground up. In his “island economy” models and the landmark Microeconomic Foundations of Employment and Inflation Theory (1970), he built unemployment from individual decisions:

• Search and matching: Workers don’t know all available jobs; they must search. Firms don’t know all available workers; they must recruit. This search process takes time, generating unemployment even in a healthy economy
• Wage setting under imperfect information: Firms set wages without knowing exactly what other firms are paying. Each firm faces a tradeoff — higher wages attract better workers but cost more. The aggregate result of these individual decisions determines the natural rate
• Efficiency wages: Firms may pay above-market wages to motivate workers, reduce turnover, or attract talent — creating involuntary unemployment as a byproduct

These microfoundations connected macroeconomic outcomes to individual behavior — a methodological advance that influenced the entire field.

His 2006 Nobel Prize was awarded “for his analysis of intertemporal tradeoffs in macroeconomic policy.”

Explain It to a Child

Imagine your teacher says: “If you all talk quietly, I’ll give you extra recess.” At first it works — everyone whispers and gets extra playtime. But soon kids figure out the trick and start talking louder, knowing extra recess is coming anyway. Now the teacher has to promise even MORE recess to keep things quiet, but kids keep adjusting. Eventually, you have tons of promised recess but the classroom is just as noisy as before. That’s what Phelps discovered about inflation and unemployment: the government can trick people into working more by creating surprise inflation, but once people catch on and expect it, the trick stops working. You end up with high inflation and the same unemployment you started with.