Finn Kydland (currently affiliated with Carnegie Mellon University and the University of California, Santa Barbara) and Ed Prescott (currently affiliated with Arizona State University and the Federal Reserve Bank of Minneapolis) have won this year's Nobel Prize in Economic Science. The two were cited for their pathbreaking work on "time inconsistency" and "real business cycle theory."
It would be difficult to overstate the influence that Kydland and Prescott's work has had on macroeconomics, in both academic and policy worlds. It had an enormous impact on how we think about monetary policy at the Cleveland Fed. In an essay written for our 1999 annual report, we confessed.
If you ask us to name the three theoretical developments that have had the most significant influence on economic policy thinking in the past 30 years, we answer: rational expectations, time inconsistency, and “real” business cycles.
The first two would raise few eyebrows among academics. Rational expectations, brought to modern macroeconomics by Nobel laureate Robert E. Lucas, Jr., introduced forward-looking behavior into policy discussions in a formal and systematic way. This sounded the death knell for the Phillips curve as an exploitable tool of policy and spawned a rich, varied literature on the vital role of expectations in the dynamics of economic activity.
Related to rational expectations, time inconsistency predicted adverse consequences from economic policies that failed to commit to clear and consistent long-term objectives. This was an old but underappreciated principle that applied to the formulation of economic policies. Because of dynamic rational expectations, short-run policies that, individually, appear to be reasonable (if not optimal) in the short run, are decidedly less than optimal when considered over time.
These two contributions emphasize the importance of rules, as opposed to discretion, in economic policy. But not any rule will do. The policy rule must commit to future actions today and the policymaker must be held accountable to them. In the case of monetary policy, the problem of time inconsistency implies that the monetary authority should emphasize transparent, credible policies regarding the future purchasing power of money.
Without commitment, the rule on which inflation expectations are formed is not credible, since the public knows that at any point, the monetary authority will be tempted to renege on its long-run promise in the interest of short-run expedience. Clearly these ideas have taken hold, and they provide much of the current intellectual underpinnings of central banks’ behavior all over the world—not least because they explain how policy had previously erred.
We expanded on the real business cycle contribution in our 2000 annual report:
Kydland and Prescott’s contributions helped us to see the possibility that business cycle fluctuations can and should be viewed as part of the same dynamic process that determines the economy’s long-term growth. This is a critical insight, because it tells us that policymakers who focus on countercyclical stabilization policies may inadvertently interfere with long-term economic growth. Kydland and Prescott’s perspective also reminds us that we can learn a great deal about economic performance by looking at factor inputs (labor, capital, and land) and factor returns (wages, interest rates, profits, and rents)—a lesson that is very different from the standard Keynesian output–expenditure bill of fare.
This award was richly deserved.