A potted history of macroeconomics as a discipline runs something like this: almost a century ago, John Maynard Keynes theorised how policymakers – either through fiscal or monetary tools – could alleviate the fluctuations of the business cycle, leaning against both recessions and unsustainable booms to stabilize the economy. That Keynesian model came under severe theoretical challenges in the decades afterwards and seemed to fall apart, in the real world, over the course of the 1970s when the relationships between inflation and unemployment implied by the theory appeared to break down. That triggered all sorts of policy experimentation over the course of the 1980s and early 1990s. Nowadays, though, there is a reasonably broad consensus that independent inflation-targeting central banks have a large role to play in managing the fluctuations of the business cycle.
…demonstrating how economic models could be reconstructed to revitalise stabilisation policy. Rather than basing the models on statistical links between macroeconomic variables, such as inflation, production and consumption, they chose to build them on a microeconomic foundation. This encompasses an understanding for how the total mass of individual households and businesses affect the economy through their actions.
This was an important shift. Whereas previous Keynesian, and indeed Monetarist, models of the macroeconomy had been based on linkages between economic variables at the aggregate level, this new framework – sometimes dubbed New Keynesian – shifted the focus down to the level of households and firms.
As the Nobel committee explained:
A central component in these models is that households and businesses are forward looking when making decisions about savings or product prices. When governments and central banks communicate their plans for economic policy, they can influence this view of the future and move the economy in the right direction.
As is often the case with Nobel prizes, the work of the two is complementary but distinct. Hall’s research focused on households and how they attempt to smooth their spending over time in the face of positive and negative shocks. This is a core building block of most modern macroeconomic models. Whereas Woodford is best known for 2003’s Interest and Prices, which is very much the bible of modern central banking. It sets out a model with imperfect competition between firms, occasionally sticky prices, and optimising agents. Central banks, in the world, can influence economic outcomes both via changing their policy rates and by shifting expectations of future rates.
Taken together, the laureates helped to build the so-called microfoundations on which much of modern economics rests.
If nothing else, that has helped give the discipline as a whole a more coherent feel. The gap between what a microeconomic approach and a macroeconomic one might suggest had long been recognised as problematic. In 1967, Kenneth Arrow (winner of the 1972 Nobel) argued it was ‘a major scandal’ that the kind of price theory taught and studied in microeconomics classes appeared to rule out the possibility of involuntary unemployment. Robert Lucas (a 1995 winner) and Thomas Sargent (who had to wait until 2011 for his prize) famously argued in 1979 that macroeconomics was ‘fundamentally flawed’ by its lack of microfoundations.
As one of your columnists’ own economics professors once explained to him, it had always felt strange to send undergraduates to a lecture on microeconomics on Monday and then to an inconsistent one on macroeconomics on Tuesday.
Of course, Hall and Woodford have not been awarded the prize just for making economics tidier or for lowering the levels of cognitive dissonance required to teach both macro and micro courses to students. Rather, they have been awarded it for their work in ‘revitalising stabilization policy’.
The Clark Center’s US and European Economic Experts Panels both believe this was well deserved. Asked whether ‘building macroeconomic models on the forward-looking decisions of individual households and firms, rather than on estimated relationships among aggregates alone, has substantially improved the ability of policymakers to stabilize the economy’, more than 90% of US panel respondents and more than 75% of European panel respondents (both weighted by confidence) either strongly agreed or agreed.
As Pete Klenow of Stanford neatly summarised it, ‘Hall showed consumers look ahead, so temporary checks are mostly saved. Woodford showed monetary policy works through the expected rate path, so credibility is the instrument: forward guidance at the lower bound, anchored expectations after the 2021-2022 inflation’. Although Larry Samuelson of Yale, while agreeing, added a note of caution, ‘The economy is an immensely complicated self-referential system, and stabilization remains difficult and elusive. The new macro models have improved our understanding and abilities, but [more] remains to be done’.
Interestingly, some of those less likely to agree were former policymakers. Patrick Honohan of Trinity College Dublin, for example, a former governor of the Central Bank of Ireland and member of the ECB’s central committee, was uncertain. He argued that ‘These elegant models have greatly assisted understanding and have been useful for strategic planning. Their usefulness in tactical decision making has been less effective’. Olivier Blanchard, a former IMF chief economist now at the Peterson Institute, disagreed, arguing that this was a ‘false choice’ as, ‘you can work with aggregate, and have expectations explicitly on the right hand side’.
Stable is probably not the word that comes to mind when anyone thinks of the last couple of decades of economic performance across the advanced economies. But stabilization policies have played an, at times, vital role. The work of Hall and Woodford has been an important underpinning of this.
