Norwegian, American Win Nobel Economics Prize By Jan Strupczewski and Stephen Brown
STOCKHOLM (Reuters) - Finn Kydland of Norway and Edward Prescott of the United States won the Nobel economics prize Monday for research that laid the groundwork for more independent central banks and explained business cycles.
"Their work has not only transformed economic research, but has also profoundly influenced the practice of economic policy in general, and monetary policy in particular," the Royal Swedish Academy of Sciences said in its citation.
"It is the greatest possible accolade. There is no doubt about that," Kydland, who teaches at Carnegie Mellon University and the University of California, told NTB news agency in Norway, where he is lecturing.
Kydland, 60, shares the 10 million Swedish crown ($1.36 million) prize with Prescott, 63, who works at Arizona State University and the Federal Reserve (news - web sites) Bank of Minneapolis.
Michael Crow, president of Arizona State University, praised Prescott's "great intellect, drive and commitment."
In the late 1970s and early 1980s the two men transformed analysis which, with its focus on changes in demand like investment and household consumption, had been unable to explain the widespread phenomenon of "stagflation" -- the combination of high inflation with no growth and high unemployment.
Their 1977 article on the "time consistency problem" showed that policy makers tend to abandon longer-term aims to milk shorter-term benefits -- for example, setting out to keep prices stable, but then fomenting inflation to reduce debt.
This helped shift the focus of policy-making to independent and credible institutions, laying the groundwork for the creation of the European Central Bank, said John Hassler at Stockholm University.
"We have seen a move toward more independent central banks with various forms of inflation targets. This reform movement we think is a direct implication of the kind of research in Kydland and Prescott's first article," said Prof. Torsten Persson, chairman of the prize committee.
In 1982 the pair created a model showing that supply-side shocks -- such as technological advances -- are a driving force behind the business cycle rather than variations in demand alone.
"Whereas earlier research had emphasized macroeconomic shocks on the demand side of the economy, Kydland and Prescott demonstrated that shocks on the supply side may have far-reaching effects," said the Academy.
The economics award was not among the original prizes -- for chemistry, physics, literature, medicine and peace -- founded by Alfred Nobel, inventor of dynamite, in his will in 1895.
It was instituted by Sweden's central bank in 1968 and first awarded the following year.
(Additional reporting by Karin Lundback and Inger Sethov)
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<http://nobelprize.org/economics/laureates/2004/press.html>
Press Release: The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 2004
11 October 2004
The Royal Swedish Academy of Sciences has decided to award the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, 2004, jointly to
Finn E. Kydland Carnegie Mellon University, Pittsburgh and University of California, Santa Barbara, USA, and
Edward C. Prescott Arizona State University, Tempe, and Federal Reserve Bank of Minneapolis, USA
"for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles".
New theory on business cycles and economic policy
The driving forces behind business cycle fluctuations and the design of economic policy are key areas in macroeconomic research. Finn Kydland and Edward Prescott have made fundamental contributions to these areas of great significance, not only for macroeconomic analysis, but also for the practice of monetary and fiscal policy in many countries.
Time Consistency of Economic Policy
The higher taxation of capital households expect in the future, the less they save; the more expansive monetary policy and the higher inflation firms expect, the higher prices and wages they set, etc. The Laureates showed how such effects of expectations about future economic policy can give rise to a time consistency problem. 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. Kydland and Prescott's results offered a common explanation for events that, until then, had been interpreted as separate policy failures, e.g., that economies become trapped in high inflation even though price stability is the stated objective of monetary policy. Their awarded work established the foundations for an extensive research program on the credibility and political feasibility of economic policy. This research shifted the practical discussion of economic policy away from isolated policy measures towards the institutions of policymaking, a shift that has largely influenced the reforms of central banks and the design of monetary policy in many countries over the last decade.
Driving Forces Behind Business Cycles
Research by the Laureates also transformed the theory of business cycles by integrating it with the theory of economic growth. Whereas earlier research had emphasized macroeconomic shocks on the demand side of the economy, Kydland and Prescott demonstrated that shocks on the supply side may have far-reaching effects. 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. Previous business-cycle models had typically been based on historical relations between key macroeconomic variables. But models that had functioned quite well during the 1960s began to break down under the more turbulent economic conditions of the 1970s, with oil-price shocks and concurrent inflation and unemployment. The Laureates laid the groundwork for more robust models by regarding business cycles as the collective outcome of countless forward-looking decisions made by individual households and firms regarding consumption, investments, labor supply, etc. Kydland and Prescott's methods have been widely adopted in modern macroeconomics.
more: <http://nobelprize.org/economics/laureates/2004/ecoadv.pdf>