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.
Read more about this year’s prize
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Finn E. Kydland, born 1943 (60 years) in Norway (Norwegian citizen). Ph.D. from Carnegie Mellon University, Pittsburgh in 1973. Professor at Carnegie Mellon University and University of California, Santa Barbara, USA.
Edward C. Prescott, born 1940 (63 years) in Glen Falls, NY, USA (US citizen). Ph.D. from Carnegie Mellon University, Pittsburgh in 1967. Professor at Arizona State University, Tempe and researcher at Federal Reserve Bank of Minneapolis, USA.
The Prize amount: SEK 10 million, will be shared equally among the Laureates.
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Their work and discoveries range from the Earth’s climate and our sense of touch to efforts to safeguard freedom of expression.
See them all presented here.