Nobel:"effects of expectations about future economic policy"-Bush deficit

expectations and their effects on the economy? - Seems to Say Dems are correct about Bush causing the recession and poor recovery - I wonder if the media will pick up on this.

:-)

Excerpts from the citation awarding the 2004 Nobel Memorial Prize in Economic Sciences to Finn E. Kydland of Norway and Edward C. Prescott


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 create a time consistency problem.

If economic policy-makers 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, for example, 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 toward 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.

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 (gross domestic product), 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.

http://www.nytimes.com/2004/10/12/business/12nobel.html?oref=login&oref=login&oref=login

An American and a Norwegian economist were awarded the Nobel in economics yesterday for their efforts to demonstrate that innovative technologies and shocks, like a sharp increase in oil prices, play a much greater role in causing booms and recessions than fluctuations in demand.

The $1.3 million Nobel Memorial Prize in Economic Science went to Edward C. Prescott, 63, and Finn E. Kydland, 60, for two papers they wrote between 1977 and 1982. Their findings contradicted Keynesian theory, which held that changes in demand, particularly consumer demand, played the greatest role in business cycles. The Prescott-Kydland papers "transformed academic research in economics'' and also transformed policy making, the Royal Swedish Academy of Sciences said in its citation.

Their first paper, which appeared when both were at Carnegie Mellon University in Pittsburgh, argued in effect that government officials should adhere to rules rather than resort to short-term policy shifts when circumstances change. If holding down inflation is the Federal Reserve's goal, for example, then the Fed should refrain from sharp cuts in interest rates during hard times, an approach that might result in too much stimulus and too much inflation later on. Better to resist changes in policy and suffer through some hardship if minimizing inflation makes people better off in the long run, their thesis maintained.

The two economists developed their second paper in the summer of 1980. Mr. Kydland had returned temporarily to his undergraduate alma mater, the Norwegian School of Economics and Business Administration in Bergen, and Mr. Prescott had gone there as a visiting professor with his wife and three children. Out of that collaboration came the view that supply shocks or new technology produce booms and busts, not changes in demand.

Alas, the second paper was a bit ahead of it's time. Instead we ended up with "Greenspinian econmic theory" ;-)

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