A Columbia University economist was awarded the Nobel Prize in economics Monday for his paradigm-shifting work showing that reducing inflation wouldn't necessarily lead to higher unemployment - a key tenet of Federal Reserve policy since the 1980s.
Edmund S. Phelps, 73, was honored for his challenge to a post-World War II notion that low inflation and low unemployment couldn't exist simultaneously. That notion was embodied in the so-called Phillips curve.
Phelps, however, theorized in the 1960s that the drivers of inflation go beyond the level of employment and wages. He faulted the strictly statistical Phillips curve for failing to take into consideration how the expectations of people and companies about price and wage inflation affect their purchasing and employment decisions.
In his model, stimulative economic policies such as reducing interest rates and taxes boost employment in the short-term but create a longer-term inflation problem.
Phelps' theory gradually took hold. But not before monetary policymakers grappled in the early 1970s with an oil crisis, rising unemployment and slipping productivity. They responded by loosening monetary policy - an effort that later was seen through the lens of Phelps' theory as a contributor to the era's troublesome inflation.
In the early 1980s, the Fed under then-Chairman Paul Volcker reversed course and sharply raised interest rates to reduce inflationary expectations. In the short run it produced a recession, but those policies - also adopted by the next Fed chief, Alan Greenspan - eventually helped lead to the low inflation and strong employment growth of the 1990s.
Today, Phelps' ideas, particularly the value of holding down inflation, are a key part of monetary policy under Fed Chairman Ben S. Bernanke. The central bank chief considers consumer and corporate expectations in deliberating interest rate adjustments.
It was a groundbreaking theory, said John B. Taylor, a professor of economics at Stanford University who worked with Phelps at Columbia in the 1980s.
"Everybody would like to have low inflation," Taylor said. "Everybody would like to have low unemployment. But there used to be - before he wrote - an idea that you couldn't have both. He had the notion that there really wasn't this trade off."
Phelps' work "deepened our understanding of the relation between short-run and long-run effects of economy policy," said the Royal Swedish Academy of Sciences, which hands out the Nobel prizes.
Phelps' victory, including a $1.37 million purse, gave Americans all six of the 2006 awards so far. The last two prizes, in literature and the Peace Prize, are to be announced later this week.