Why Prescott, Kydland won the Nobel

This year, the Nobel Prize for Economics is being awarded to Edward Prescott, who works at Arizona State University and the Federal Reserve Bank of Minneapolis, and Finn Kydland, who teaches at Carnegie Mellon University and the University of California. The duo has been selected for the 2004 award for their research work, specifically two papers they published in 1977 and 1982, which focussed on issues that were closely related. The 1977 paper on â€œtime consistency problemâ€� went into the design of economic policies, while the 1982 paper looked into the causes of business cycles. The duoâ€™s research proved that policy makers tend to abandon long-term aims to milk shorter-term benefits. Their work helped shift the focus of policy making to independent credible institutions and this was what led to creation of the European Central Bank. What is the time consistency problem? Kydland and Prescott, in their 1977 article, showed the difference between time-inconsistent and time-consistent problems. A time-inconsistent policy may make the public happy in the short run but will ultimately fail to produce the long-run policy goal. A time-consistent policy, in contrast, nails the long-run policy goal but does not make people unhappy in the short run. In an interview to ABC, Warwick McKibbin, director of the Centre for Applied Economic Research at the Australian National University, said that Prescott and Kydland, through their research, came to the conclusion that governments have a temptation to announce a policy. In such a scenario, everybody adjusts to that policy and make various commitments. Then the government has the incentive to change the policy and exploit the fact that people have already pre-committed. Says McKibbin, â€œAnd so their (Prescott and Kydland) idea was that this is a problem, and it led to countries with high inflation and a whole range of other issues, because the private sector kept anticipating what the government would do in terms of cheating, and so they made the point that it was a problem, and secondly, they set up a set of rules for how you might avoid this.â€� On what basis are economic policies made? Economists categorise policies as either according to rules or by discretion. According to an article by Jason J Buol and Mark D Vaughan in The Regional Economist published by the Federal Reserve Bank of St Louis, in a rules framework, policy responses must follow a pre-specified plan. The plan can be non-activist in nature â€“ the rule may force policy-makers to pursue the same course of action in all circumstances. Or the plan can be activist in nature â€“ the rule may direct policy-makers to respond to different circumstances in different pre-determined ways. The common denominator is that rules are supposed to constrain policy-makersâ€™ actions in advance. In a discretionary framework, policy-makers have wide latitude to design the best policy response for the given circumstances. According to proponents of the discretionary policy, such flexibility allows policy-makers to respond to unforeseen scenarios. What was the theory offered by Prescott and Kydland? Prescott and Kydland argued that policies should be rules-based. According to them people follow policy-makersâ€™ decisions and also have a lot of expectations from them. Policy-makers with discretionary powers can renege on promises they made and this will reduce their credibility. The people will then not take the pronouncements of policy-makers seriously. Hence there should be a rule that binds the policy-makers to their pronouncements. And this can be made in a number of ways like through constitutional amendments. Kydland and Prescott stressed on the importance of pondering not only the desirable policy for a given set of circumstances but also the framework likely to produce the best policy over time. They argued that rules produce time-consistent outcomes because they make policy-makersâ€™ pronouncements credible. However, Prescott and Kydland were not the first to emphasise on rules-based policy making. Points out Buol and Vaughan, in the 1930s, Henry Simons argued that monetary rules reduce uncertainty about the price level and, thereby, facilitate private-sector planning. Milton Friedman too extended the argument, noting that real-world policy-makers have imperfect information and imperfect tools; so, even the best-intentioned attempts to combat fluctuations could end up destabilising the economy. Geoffrey Brennan and James Buchanan have justified monetary rules on political grounds â€“ discretion permits the central bank to generate a higher-than-socially-optimal inflation rate so that it can enjoy the revenue from money creation. What Kydland and Prescott have shown is that discretionary policy can produce undesirable long-run outcomes â€“ in the monetary-policy case, higher inflation with no reduction in unemployment â€“ even in a world with little uncertainty, good policy tools and public-spirited policy-makers. So, should economic policy-making be based on rules? Discretionary policy cannot be discarded altogether. Such policy-making becomes useful in uncertain environments. Policy-makers vested with discretionary powers can overcome unforeseen problems through innovative solutions. However, such policy-making should be free from political interference. Only then can the pronouncements of policy makers stay credible. What are business cycles? The business cycle or economic cycle refers to the ups and downs seen somewhat simultaneously in most parts of an economy. They tend to repeat at fairly regular time intervals. The cycle involves shifts over time between periods of relatively rapid growth of output, alternating with periods of relative stagnation or decline. These fluctuations are often measured using the real gross domestic product. Most observers find that the lengths of cycles (from peak to peak, or from trough to trough) vary, so that cycles are not mechanical in their regularity. Since no two cycles are alike in their details, some economists dispute the existence of cycles and use the word fluctuations (or the like) instead. Others see enough similarities between cycles that the cycle is a valid basis of studying the state of the economy. A key question is whether or not there are similar mechanisms that generate recessions and/or booms that exist in capitalist economies so that the dynamics that appear as a cycle will be seen again and again. Prescott, in an article, writes,â€�I... do not refer to business cycles, but rather to business cycle phenomena, which are nothing more nor less than a certain set of statistical properties in a certain set of important aggregate time series. What, according to Kydland and Prescott, led to business cycles? According to McKibbin, it was Kydland and Prescott who invented the real business cycle theory. â€œThe (Prescott-Kydland) theory... says that what we observe in the business cycle is not coming from the demand side and mistakes by wage setters and rigidities and errors, but it''s driven by the supply side of the economy, such as shocks to productivity or shocks to oil,â€� explains McKibbin. Prescott and Kydland then brought the supply side into the argument about economic policy. Simply put, what one observes in big fluctuations in economies may not have been the result of mistakes, but the result of optimal behaviour of people in response to unanticipated events. How can the work of Kydland and Prescott be considered revolutionary? Kydland and Prescottâ€™s work can be considered revolutionary because they defied the Keynesian paradigm which has been dominant since the 1930s. While the Keynesian paradigm stated that people cared only about demand, Prescott and Kydland said that people cared not only abour demand, but also about things like productivity and structural shocks. Their work, according to McKibbin, has become very influential in macroeconomics literature, and more widely, one can apply the same ideas right across in terms of time consistency to things like nuclear deterrents, a whole range of different areas in society.

Why Prescott, Kydland won the Nobel

The duo has been awarded for their research work on economic policy making and business cycles.

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