2004 Nobel Prize Winners - Economics

Recent thinking in Economics: Nobel Prize winners 2004.

Nobel Prize Winners

2004: Finn E. Kydland & Edward C. Prescott

Edward C. Prescott

Image: Edward C. Prescott. Copyright: The Nobel Foundation

Finn Kydland is the Henley Professor of Economics at the University of California in Santa Barbara. Kydland joined the University of California in July 2004 from Carnegie Mellon University, Pittsburgh, Pennsylvania where he gained his PhD in 1973.

Edward C. Prescott is the W.P. Carey Chair of Economics at Arizona State University, which he joined from the University of Minnesota in autumn 2003. He is also a senior advisor at the Minneapolis Federal Reserve Bank.

Prescott met Kydland at Carnegie Mellon, where Prescott was Kydland's PhD advisor. The two have worked together since that time and received their Nobel Prize "for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles". (Source: Nobelprize.org)

Kydland and Prescott's work centres on the debate surrounding the changes in economic activity over a period of time. Traditional economics and business textbooks refer to 'business cycles' and imply that the behaviour of economies (systems involved with the process of buying and selling - exchange) follows some sort of pattern in which real growth fluctuates around its trend. The trend in this instance can be regarded as the expected rate of growth in economic activity over a period of time regardless of any interference from government or outside agencies. Thus, in theory, if the economy were just allowed to go its own way, there would be a gradual upward trend. This can also be thought of as potential growth or the potential capacity (aggregate supply (AS)) of the economy.

Finn Kydland

Image: Finn Kydland. Copyright: The Nobel Foundation

Kydland and Prescott refer to the work of Robert Solow, who himself won a Nobel Prize in Economics, who developed a theory of economic growth that has come to be used widely in relation to developing countries. This theory suggested that real output per worker and the stock of real capital grow at a mainly constant rate and that the capital to output ratio has no systematic trend and profit in relation to capital has a broadly horizontal trend.

The question they were interested in was not measuring business cycles but focusing on the pattern of output and employment around the trend and asking why this seemed to happen in a repeated fashion over time.

In analysing the behaviour of economies they seek to challenge a number of economic myths that have grown up around business cycles. For example, in times of economic downturn we would expect the price level to be falling and in times of strong economic growth we would anticipate prices rising. This relationship can be referred to as 'procyclical'. In a downturn, the theory would suggest that firms are seeking to reduce prices to encourage sales and are prevented from increasing prices to improve margins because of the lack of demand. Similarly, in times of economic growth, firms experience rising demand and possibly wage and other costs. They are able to increase prices to improve margins without too much damage to business because of the strong growth in demand.

Kydland and Prescott argued that in fact, price showed a counter-cyclical behaviour - when economic growth slowed down, prices rose and when economic growth was strong, prices fell. They further argue that there are other myths surrounding business cycles. These include the idea that real wages fall as growth increases and vice versa (or are not related to the business cycle) and that the money supply is an important factor in leading economic growth.

The Business Cycle:

Most textbooks - even modern ones - are likely to explain the business cycle in terms of four phases. The term 'cycle' implies a 'what goes around comes around' type of approach to an economy. Such a view of cycles implies an almost inevitable trend where growth turns into boom, which in turn leads to the start of decline that leads to recession before the process begins again. However, Kydland and Prescott do not see cycles in this way. Instead they prefer to use a generally agreed scientific definition of 'cycles' that makes reference to a point of departure - in this case the trend of economic growth. Kydland and Prescott refer to these recurrent departures as 'deviations'.

They argue that business cycles must be seen as periodic deviations from trend growth and that we cannot view business cycles as inevitable or evolutionary. As such the explanation for a downturn in economic activity cannot, in itself, be found in the reasons why growth occurred in the first place. Equally, the seeds of an expansion in growth are not to be found in a recession.

This helps, in part, to answer the question often posed by students as to why, when an economy is experiencing a boom, should it inevitably lead to a downturn; why should consumers and producers suddenly change their decision making to anticipate a downturn when things appear to be so good?

Price procyclicality is important because if we are looking for the causes of changes in economic activity as a whole, we would presume to be looking for something fairly major as being the cause - large price rises, for example, or shocks caused by changes in things like the money supply. If price procyclicality is a myth then research into the causes of changes in cycles might be misguided. Think of it in terms of a thermometer in a room. The thermometer tells us what the temperature of the room is but is not a cause of the temperature. Looking at the properties of the thermometer to explain the temperature of the room would lead us down the wrong path.

You can investigate the relationships and do your own analysis between key aspects of economic data in the Key Economic Data.

Kydland and Prescott argue that an important factor in explaining business cycles is the decisions people make about how they devote their time between leisure (non-market activities) and income-earning activities. After analysing the factors that may influence business cycles they come to the following conclusions:

  • Aggregate hours worked (a measure of labour input) is strongly correlated with changes in GNP. The problem with this is that the contributions to GDP for all workers are considered the same. Kydland and Prescott point out that the contribution by the hours worked by a brain surgeon are not the same as that of a porter in a hospital. With some consideration of this, Kydland and Prescott conclude that real wages are more procyclical and something which traditional literature on business cycles would not suggest.
  • The capital stock is largely unrelated to real GNP but is closely correlated if a time lag of about one year is included.
  • The factors affecting aggregate demand - consumption, investment and government spending - Kydland and Prescott report that consumption and investment are highly procyclical whereas government spending does not seem to be correlated with growth.
  • They also comment that imports are procyclical as are exports but with a six month to a year time lag.
  • Labour and capital income is strongly procyclical.
  • They find no evidence that narrow money (M1) leads the business cycle. In other words they do not find evidence that a rise in M1 will lead to a spurt in growth. Indeed, the central bank in Japan has been pumping cash into the system for the last five years but it has not led to the desired spending boost that might have been hoped for.
  • Credit arrangements are likely to play a significant role in future analysis of business cycle theory.
  • The price level is countercyclical.

The Implications:

The discussion above raises important implications for economic research in that it challenged the traditional method of analysing economic data. They are suggesting that in order to look at what might be happening in economics it might be necessary to look at factors other than those that simply describe the data.

This emphasis on the quantitative features rather than qualitative features (what it tells us rather than what we think it might signify) has been a feature of a re-assessment of statistical analysis in economics particularly the analysis of time series data. What do long-term time series tell us in relation to short-term series?

Their work led to the development of the rational expectations school of thought. This school believes that individuals will react to changes in economic policy that might affect the success of that policy. For example, if individuals believe that the government, for example, are intending to restrict the rate of growth of wages in the public sector as a means of putting pressure on private sector pay to be curbed, they may adapt their behaviour to reduce spending in anticipation of that fact that their incomes will not rise as much as they might have hoped. This will therefore have an impact on the economy as a whole different to that which the government might have hoped from the policy.

The notion of 'real business cycles' therefore does not view a recession as a 'failure' in the economy nor might a boom also be seen as a failure. How many times do we see politicians complaining about the 'bad old days of boom and bust'? Kydland and Prescott see business cycles as explanations of shock to the economy that are understandable reactions rather than failures.

Their work tends to dismiss the 'sticky prices' explanation for a slowdown in growth, it also might reject the mismatch between investment and consumption and the monetarist argument of market failure in price signals. Instead they look at real shocks to the economy and the adjustment process to those shocks, which could last for some time after the shock. Essentially, Kydland and Prescott argued that business cycles could occur perfectly naturally within a competitive environment despite the implication in traditional theory that perfect competition would not result in long periods of unemployment, for example.

Like many who win the Nobel Prize therefore, Kydland and Prescott's work challenges traditional thinking and assumptions and provides a new framework to understand, in this case, changes in economic activity over time, that enables policy makers and researchers to make more informed decisions and judgements. It is worthwhile therefore considering such new thinking in discussions about business cycles - at the very least, it will impress examiners if you are able to recognise that there is a new line of thinking on such issues even if others have offered some critique of the position that Kydland and Prescott offer - that is what economic debate is all about.