Arnold Kling  

Kydland and Prescott win Nobel

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This year's Nobel Prize in economics was awarded to Finn E. Kydland and Edward C. Prescott for their work on time inconsistency of economic policy and real business cycles. The press release describes these discoveries as


If economic policymakers lack the ability to commit in advance to a specific decision rule, they will often not implement the most desirable policy later on...

In their business-cycle model, realistic fluctuations in the rate of technological development brought about a covariation between GDP, consumption, investments and hours worked close to that observed in actual data.


I like a lot of Prescott's work. However, I never liked the "expectations" model of employment fluctuations that was the basis for the time-consistency story. That is, I just don't think of our decentralized markets as producing decisions about wage offers that are based on predictions of monetary policy. There are too many other things for individual actors in the economy to worry about.

UPDATE: So far, the best mainstream media piece I've seen on the Nobel winners is David Henderson's in the Wall Street Journal. My favorite blog pieces have been at Marginal Revolution (here, here, here, and here); and at David Tufte (here and here).

For Discussion. Does the work of Groshen and Potter, which points out that relatively few workers are on temporary layoff and more job losses reflect permanent restructuring, suggest that a "real" or "supply-side" model of a recession is particularly appropriate today?


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CATEGORIES: Macroeconomics



TRACKBACKS (6 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/141
The author at PRESTOPUNDIT -- "It's a team sport, baby!" in a related article titled KYDLAND & PRESCOTT writes:
    win the Nobel Prize in Economics. Reactions: From the Mises Institute. From Tyler Cowen, also here. From Arnold Kling. From Alex Tabarrok.... [Tracked on October 11, 2004 10:11 AM]
The author at Capital Flow Watch in a related article titled Nobel Prizes in Economics 2004 writes:
    Finn Kydland and Edward Prescott were awarded the Bank of Sweden Prize in Economic Science in Memory of Alfred Nobel for 2004 for their work in "time-consistent policy and the generation of the business cycle". As is the case with... [Tracked on October 26, 2004 1:18 PM]
COMMENTS (6 to date)
Jim Glass writes:

The 2004 IgNobel prizes have been awarded as well.

There's some pretty good stuff there too!

(Krugman, alas, was passed over again by both prize committees. Better luck next year.)

I'm a big fan of Kydland and Prescott, particularly of their best-known joint work:

"Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy 85 (June 1977): 473-91

but also of their individual contributions in macroeconomics and international macro. Their work moved forward the integration of macro-, micro-, and international economic analysis.

AK: However, I never liked the "expectations" model of employment fluctuations that was the basis for the time-consistency story. That is, I just don't think of our decentralized markets as producing decisions about wage offers that are based on predictions of monetary policy. There are too many other things for individual actors in the economy to worry about.

Arnold: I'm curious what doesn't hit home for you with regard to people making employment decisions based on their predictions and expectations about nominal prices. Not only is there a goodly body of evidence to support this, but also it accords with years of casual observations by most people I know.

I don't mean to misread you. Though you said "predictions of monetary policy," throughout the literature it is clear that the assumption is that people's predictions are based not on monetary policy per se but on observed nominally-denominated market prices. Monetary policy is a major factor that influences those prices. Sure, prices change for reasons other than monetary policy! And those real shocks may be the sources of the underlying problems.

But monetary policy is a big component that always lies in wait as a complication when I try to sort out what I observe. Monetary policy is quick-acting and historically reliable for the government to use as a short-run tool; and thankfully it's cheap for private citizens to monitor even if the timing of its effects isn't perfect; and it's easy to model. No matter how it works out in detail, though, monetary policy is just a proxy for the result: changes in the general price level.

People do make real decisions about jobs to take, houses to buy, where to relocate, which long-term investments to undertake, etc., based on their best guesses about the future. Nominal prices, wages, and interest rates are readily available indicators, and in economies that are not experiencing high or variable inflation they are a big component of those guesses. The fact that expected nominal prices do not always move as predicted seems very much to be a primary source of painful readjustment after the fact.

There are too many other things for individual actors in the economy to worry about.

If not inflation and its effects on eating into my future wages, savings, prices of things I'll buy such as housing costs, medical costs, college tuition, etc., then what are those other things you think I'm worried about all the time?

Kydland and Prescott highlighted critical aspects of how we think about government policy, monetary and otherwise. Is the goal for the government to use the available tools, such as monetary policy, to manipulate or engineer some short-term outcomes at the expense of other short-term or long-term outcomes, or to hold to a course known to the public even if there are some short-term losses, in order to facilitate long-term security in making plans? How would the public enforce the latter, specifically in a democracy, if administrations can change every few years?

Jim Glass writes:

Nobel Laureate Calls For Steeper Tax Cuts in US

Mon Oct 11, Washington, AFP

Edward Prescott, who picked up the Nobel Prize for Economics, said President George W. Bush's tax rate cuts were "pretty small" and should have been bigger... "Tax rates were not cut enough," he said...
~~~~

("Grover Norquist is still running the Nobel committee", mutters Krugman...)

Austin writes:

Lauren,

Arnold isn't saying that the market pricing doesn't reflect monetary policy. He is saying that market pricing doesn't immediately reflect expected monetary pricing.

You are implying that market pricing immediately reflects the expected future with no bias.

Price inelasticity is a known effect. It shows that there is a bias towards market pricing not changing as quickly as it should.

Therefore, I think the fundamental problem with Prescott's thesis is that it doesn't take into account price inelasticity.

Hi, Austin.

You commented:

You are implying that market pricing immediately reflects the expected future with no bias.

Well, actually, I don't think I said that. I was just curious what Arnold had in mind when he said there are a lot more important things that people worry about in their daily lives.

With regard to your thoughtful comment: I think neither real nor monetary shocks are incorporated immediately in market prices. How long it takes the market participants to figure out how any given change will influence the particular goods and services they themselves buy and sell is not known and probably depends on the nature of the shock and how familiar people are with its effects.

But however long it takes, I think market prices do convey information. The question is how to sort that out.

And the next questions are: How large is the cost to people of the uncertainty involved in drawing inferences from prices; and, if the government is a contributor to that cost by engaging in erratic or unpredictable policies, shouldn't the government be constrained to stop driving up costs to its citizens?

The responses to that last question would likely be: What benefits accrue to the public from the government's not being constrained (wartime flexibility? short-term economic boosts?), and how costly is it to effect the constraints?

I'm guessing that Arnold and I would agree that there is a signal processing problem with regard to drawing inferences from prices! But we would differ quite a lot in our answers to how costly it is and what might be done about it.

Lawrance George Lux writes:

Am I the only one who thinks that the Market operates precisely on lack of information, not on the Hayek theory of decentralized knowledge. Business decisions are based upon preceptions on better or worse levels of Sales in the Intermediate term. Wage demands are made based upon the expectation of labor scarcity--or the reverse. Optimal decisions will be invariably wrong, as they are a secondary aggregation of dissolvable primary expectations.

A Real Causation to the Production Cycle comes from the factors of Production itself. Management decision will never stockpile sufficiently to meet Boom demand, out of fear of Bust conditions. Expansion of Employment must always come with Boom conditions, unsustainable because of overproduction after the initial Demand for Product is fulfilled.

Arnold,
A Supply-side model of Productivity is necessary. Who has provided adequate statistical work on the standard multiplicative factor between Boom and Bust conditions under constant capitalization? lgl

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