Nobel ideas

A central issue in policy making is the vision of the government: what should policy makers do? Should the government pro-actively jump to the rescue of people who are adversely affected by changing market conditions? For example, if the steel industry is doing badly, should the government help by cutting taxes on steel? If petroleum prices are rising should the government change the pricing policy for petroleum products? The debate on whether a government should exercise discretion and tactically change policies from time to time is one to which Finn Kydland and Edward Prescott have brought many insights.

The two economists have just won the Nobel prize for economics for two papers written in 8217;77 and 8217;82. Their first paper was on the 8220;time consistency8221; of economic policy. K038;P were the first to point out that in addition to the problems of incompetence and lobbying, there are serious and basic problems in a government that has discretion. Economic agents form expectations about the future based on present policies. But this would create opportunities for the government to 8220;cheat8221; by exploiting the situation to surprise economic agents. Hence, the only consistent outcome is one where economic agents would treat the policy announcements of the government as transitory and non-credible. The Laureates considered the possibility of conducting fiscal and monetary policy on the basis of long-run rules, which are difficult to change. A drawback of such rules, as shown by later research, is that they can be restrictive. However, owing to the work done by K038;P, the focus of policy research has shifted to institutional frameworks which deliver measures that are credible and therefore feasible.

The second front that K038;P opened was the 8220;real business cycle8221;. Traditionally, the major focus of economists was upon demand conditions in the economy, and monetary economics. It was thought that shocks to the real economy 8212; a crop that fails in one state, or a cyclone in another 8212; tend to cancel out and do not have macro effects. K038;P worked out a model where real shocks, such as the monsoon, the oil shock, or technological developments such as the internet, could have a major role in explaining business cycles. This work has become highly mainstream and macroeconomic models today are based on real business cycles.