Much of modern macroeconomics was shaped by Edmund S. Phelps, who died this May. Ned’s pioneering efforts in developing a formal theory of the coordination mechanisms governing economic interactions led the way to a new kind of macroeconomics, one that was based on the interplay between the actions and expectations of individual actors, instead of being based on postulated relationships between macro aggregates.

Macroeconomics today has a connection with microeconomic reasoning that it never did before Phelps and a handful of others transformed the subject. Many of the concepts that Ned himself introduced while making these contributions in the 1960s and 1970s remain in use on the frontiers of the discipline, including the expectations-augmented Phillips Curve, the natural rate of unemployment, efficiency wages, optimal inflation, staggered price-setting, the matching function governing aggregate hiring, and the customer-market model of price competition. These are all important concepts, and some of them are also central to the conduct of monetary and fiscal policies around the world.

It is hard for the modern student of macroeconomics to appreciate the extent to which these contributions changed the way macroeconomics is studied and used. I first started studying macroeconomics in the mid 1960s, and I recall the discontent that many of us then felt with its fragmented nature and lack of micro-foundations, a state of affairs that Kenneth Arrow (1967) rightly described as “a major scandal.” Around the same time Hahn (1965) and Clower (1967) were noting that monetary theory was fundamentally inconsistent with established general equilibrium theory, and Clower (1965) was proposing a way to bridge the gap between Keynesian economics and general equilibrium theory. By 1968, when I was just starting my graduate work in economics, the quest for a microfoundation to macroeconomics was underway, led by economists such as Clower, Leijonhufvud, Alchian, Mortensen, Hynes, Gordon, Lucas, and Rapping. Among the most prominent of these leaders was Ned Phelps.

Phelps and these other pioneers attributed much of the unsatisfactory state of macroeconomic theory to its inadequate treatment of information. The Walrasian paradigm that provided the only available coherent account of an economy’s coordination mechanism supposed that accurate information about trading opportunities and about the behavior of one’s potential trading partners was costlessly communicated at all times to all transactors, through some mechanism that was never made clear, whereas many of the key elements of contemporary short-run macro theory, such as price stickiness and the real effects of aggregate demand shocks, seemed to depend on people making decisions while being less than fully informed about trading alternatives. What was needed was a new way of thinking about coordination that took these informational imperfections into account.

Ned provided a new conceptual framework in which it was possible to analyze these imperfections systematically. This framework was deployed in Phelps (1968), and also described in the island parable that he outlined in the introduction to Phelps et al (1970), commonly known as “the Phelps volume.” 

The most visible feature of Phelps’s contributions to macroeconomics is the sheer number of his creations that are continuing to have a major impact on the profession decades later. These go well beyond the ideas I have focused on here related to inflation and unemployment, and have helped shape the literatures on economic growth, social choice, public finance, entrepreneurship, the economics of transition, and on and on.

One measure of the depth of Ned’s contributions is the number of path-breaking contributions by others that have been based on them. His island parable formed the basic conceptual framework of Lucas’s (1972) theoretical paper that launched the rational expectations revolution in the 1970s. Kydland and Prescott (1977) analyzed monetary policy using the formal framework first spelled out by Phelps (1967), and their analysis of time-consistency was to a large extent foreshadowed by Phelps and Pollak (1968). One of the concepts for which Milton Friedman was most well-known is the natural rate of unemployment, a concept that I believe owes more to Phelps than to Friedman. Instead of writing out a formal model of the determination of the natural rate, Friedman was content to say that it was the rate “that would be ground out by the Walrasian system” if appropriate account were taken of imperfections, costs of information, structural characteristics of the labor market, etc. Phelps actually provided such an account, and it involved going far beyond the Walrasian system. Phelps was also the first to introduce the concept of a “matching function,” that describes the rate of new job formation as a function of the economy-wide unemployment rate and vacancy rate, a function that underpinned the search theory for which Diamond, Mortensen and Pissarides were justly recognized.

Ned’s influence on the profession went beyond his writings. He was a friend and mentor to countless other economists. The famous “Phelps volume” provided an outlet not just to already well-known writers like Armen Alchian and himself but also to several younger writers who were destined to become leaders of the profession, like Lucas and Mortensen. I know from personal experience how much Ned’s encouragement and support could mean to someone starting out, and how exciting it was to get an unexpected phone call from him asking for help in working through a paper of yours that he had just picked up, and posing questions that took you deeper into your own work. Not many economists would have had a group of friends and followers devoted enough to put on the magnificent conference that took place in his honor in the fall of 2001, in expectation that his long-anticipated Nobel Prize was about to about to be awarded. Like an actor in one of his models, he reacted rationally to the disappointment of that expectation, only to be surprised again more happily 5 years later. He told me last year that he remembered the advice from one of the Nobel committee members, to “use the prize well.” He did.

References

Arrow, K J (1967), “Samuelson Collected,” Journal of Political Economy 75(5): 730-737.

Clower, R W (1965), “The Keynesian Counter-Revolution: A Theoretical Appraisal,” in F H Hahn and F P R Brechling (eds), The Theory of Interest Rates, Macmillan, pp. 103-125.

Clower, R W (1967), “A Reconsideration of the Microfoundations of Monetary Theory,” Western Economic Journal 6(1): 1-8.

Hahn, F H (1965), “On Some Problems of Proving the Existence of an Equilibrium in a Monetary Economy,” in F H Hahn and F P R Brechling (eds), The Theory of Interest Rates, Macmillan, pp. 126-135.

Kydland, F E and E C Prescott (1977), “Rules Rather Than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy 85(3): 473-491.

Lucas, Jr, R E (1972), “Expectations and the Neutrality of Money,” Journal of Economic Theory 4(2): 103-124.

Phelps, E S (1967), “Phillips Curves, Expectations of Inflation, and Optimal Unemployment over Time,” Economica 34(135): 254-281.

Phelps, E S (1968), “Money-Wage Dynamics and Labor-Market Equilibrium,” Journal of Political Economy76(4, Part 2): 678-711.

Phelps, E S et al (1970), Microeconomic Foundations of Employment and Inflation Theory, W. W. Norton.

Phelps, E S and R A Pollak (1968), “On Second-Best National Saving and Game-Equilibrium Growth,” Review of Economic Studies 35(2): 185-199.