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Phelps, Phillips and us

The so-called ?Phillips curve? showed that it is not usually possible to manage low inflation without sacrificing employment somewhat.

india Updated: Oct 11, 2006 22:53 IST

Very often, winners are outsiders to a game, bringing in insights not thought of before. This year’s Nobel prize winner for economics, Edmund Phelps, seems to be in the category, if not in method, at least in the substance that he has given to policy-makers worldwide. For Indians, it would be wiser to laud this than moan about his beating Columbia University colleague Jagdish Bhagwati to the honour. Mr Phelps’s contribution is on a vital aspect of full-employment economies dominated by the West, but that is increasingly relevant in a world being made in the economic image of the Occident. Choosing between acceptable levels of unemployment and inflation has been something of a moral dilemma for economists. The so-called ‘Phillips curve’ showed that it is not usually possible to manage low inflation without sacrificing employment somewhat.

This trade-off, named after the New Zealand-born AW Phillips, was the conventional wisdom that Mr Phelps overturned. He showed how low inflation led to expectations of low inflation in the future, leading to policy-making decisions by corporate and government leaders. The contention challenged the view that one had to choose between two evils of unemployment and inflation. This was out-of-the-box analysis in the world of economics. Economists observe and analyse data. But when the world of expectations is brought into the picture of reality, it becomes a more solid way of understanding economic behaviour, as Mr Phelps has.

In the Indian context, it would be wise for policy-makers to look at expectations of interest rates and what it could do to economic behaviour. At present, rates are relatively low, but they may not stay that way and any action that does not bear that in mind could lead to what, in hindsight, may prove to be irrational behaviour. Economists like Mr Phelps are there to help government leaders think of the long term. In the final analysis, theories must lead to sound practice.