The Nobel jury noted that the work by Phelps, a professor of political economy at Columbia University in New York, had improved understanding of how policy affected welfare for present and future generations.
The jury said his work "deepened our understanding of the relation between short-run and long-run effects of economic policy" and has had "a decisive impact on economic research as well as policy".
His research showed that although full employment, stable prices and rapid growth are central goals of economic policy, trade-offs occasionally need to be made between the consumption of current and future generations.
"He has emphasised that not only the issue of savings and capital formation but also the balance between inflation and unemployment are fundamentally issues about the distribution of welfare over time," the Nobel committee said on Monday.
Phelps will take home a 10 million kronor ($1.37 million) prize.
The Nobel Economics Prize is the fourth of the six coveted awards announced this year.
It is the only prize not originally included in the last will and testament of the creator of the awards, Swedish inventor Alfred Nobel.
It was created by the Swedish Central Bank in commemoration of its tricentenary in 1968, and was first awarded in 1969. The prize is funded by the bank.
The prizes for Medicine, Physics and Chemistry were awarded last week. The Literature Prize will be announced on Thursday and the Peace Prize on Friday.