Last month Edward C. Prescott and Finn E. Kydland won the 2004 Nobel Prize in Economic Sciences for two important papers they coauthored that advanced the field of dynamic macroeconomics. [...]
Prescott and Kydland have long been respected for successfully combining theory and applied economics. Their work together has focused on the interaction between theory and a society’s aggregate statistics such as the level of unemployment, inflation and productivity. Prescott, an economics professor at the W.P. Carey School of Business at Arizona State University, has been a research adviser at the Federal Reserve Bank of Minneapolis for 23 years. Kydland is an economics professor at Carnegie Mellon University and the University of California, Santa Barbara. Kydland was initially a graduate student of Prescott’s at Carnegie Mellon. [...]
“I love creating models and coming up with explicit structures I can play with,” says Edward C. Prescott. “Economists create their own worlds. We’re like little gods with our artificial economics, wanting to see what happens.” [...]
“I liked that general equilibrium language – with models and people, with substitution and thinking about what these people are doing in their environments, with borrowing and lending and knowing that there’s somebody on each side of any exchange or contract,” says Prescott.
(A general equilibrium model refers to a model of the economy that takes into account all aspects of that economy, and in which individuals, companies and institutions like the central bank make decisions they consider the smartest and most appropriate at the time. Substitution refers to the decisions individuals make such as the decision to spend money now or save it for the future.) [...]
In “Rules Rather Than Discretion,” their 1977 paper, Prescott and Kydland established that a monetary authority’s policy decisions are often time-inconsistent. This means that monetary policy changes intended to remedy an immediate problem such as unemployment will often have unintended ramifications that work against the stated goal of reducing unemployment.
When a government announces a remedy to a short-term problem, individuals and companies adjust their behavior and make new decisions based on that information. Those decisions change the economic landscape, reducing the incentives the government had in the first place for wanting to institute the policy changes. [...]
[Richard Rogerson] points out that parents who threaten to punish their children often display a time-inconsistency problem. A parent who wants to produce a certain behavior may tell a child not to do something or he will punish the child. “The hope is to influence behavior,” says Rogerson. “But the kid figures out that the parent doesn’t want to punish him, so he knows that if he does it again he won’t be punished. The parent thus has a time-inconsistent policy and cannot achieve what he wants.” [...]
The second influential paper by Prescott and Kydland mentioned in the Nobel citation was “Time to Build and Aggregate Fluctuations.” This paper turned Keynesian theory upside down by finding that business cycles were caused by supply-side shocks rather than shocks to a society’s aggregate demand. [...]
Prescott and Kydland’s business cycles paper showed that real, supply-side shocks – such as a hike in the price of oil or hurricanes hitting Florida or the invention of a new technology – by and large account for the business cycles in a well-functioning economy. “Business cycles are therefore not the result of a malfunctioning economy,” says Rogerson. “It’s the economy responding to shocks that hit it – and policymakers must therefore think differently about business cycles.” [...]
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