The Nobel Prize

Finn E. Kydland (b. 1943)


Finn Kydland was born in Gjestal, near Stavangar, Norway in 1943. He studied economics at the Norwegian School of Economics and Business Administration (NHH) in Bergen, graduating in 1968 with the Norwegian Sivil√łkonom. He remained at NHH as a research scholar for a time before moving to Carnegie-Mellon University, where he was awarded an MS in 1972 and a PhD in 1973. Kydland’s PhD adviser at Carnegie-Mellon was his fellow Laureate, Edward Prescott.

Kydland’s academic career began in 1973 when he took up the post of assistant professor at NHH. In 1976 he returned to the United States, first as visiting scholar at the University of Minnesota in Minneapolis, before moving in 1977 to Carnegie-Mellon as visiting fellow. In 1978 he was appointed associate professor at Carnegie- Mellon, becoming Professor of Economics in 1982. In 2004, a few months before the award of his Nobel Prize, Kydland took up his present post as the Henley Professor of Economics at the University of California, Santa Barbara.

Kydland’s professional work includes research associate affiliations with the Federal Reserve Banks of Cleveland, Dallas and St Louis, and he has been a member of the editorial board of Macroeconomic Dynamics since 1996. His honours and awards include the John Stauffer National Fellowship in Public Policy from the Hoover Institution at Stanford University (1982–83), and the Alexander Henderson Award for the best work in economic theory from Carnegie-Mellon in 1973. In 2004, Kydland and Edward Prescott were jointly awarded the Nobel Memorial Prize in Economics ‘for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles’ (Nobel Foundation, 2004).

During the early 1970s when Kydland and Prescott began to work together, first at Carnegie-Mellon and then in Norway, where Prescott had taken up an NHH visiting professorship, macroeconomic theory was in a state of distressed flux. The established Keynesian certainties over the efficacy of discretionary government intervention tuned to particular circumstances were giving way to worrying doubts that conventional macroeconomic policy was not only proving increasingly ineffective as a means to address its traditional objective – the preservation of full employment – it was also fast becoming associated with the emergence of inflation on a new grand scale. Economies were suffering from both rising unemployment and inflation – so-called ‘stagflation’ – and traditional Keynesian responses seemed either inadequate or, according to some, actually culpable. It was against this backdrop that Robert Lucas (see entry in this volume) formulated his now famous critique of traditional macroeconomic policy evaluation. Lucas convincingly argued that Keynesian macroeconometric models that specified general theoretical and empirical relationships between central macroeconomic variables could not be effectively used in policy evaluation since their parameters might be altered as economic agents adjust their expectations and behaviour in response to a given policy change. In other words, the policy to be evaluated may itself fatally undermine the evaluation process: a macroeconomic ‘Catch 22’.

The Lucas critique posed a serious problem for what Kydland and Prescott in their path-breaking 1977 Journal of Political Economy paper, ‘Rules Rather Than Discretion: The Inconsistency of Optimal Plans’, refer to as ‘optimum control theory’. In economic policy making this, in essence, involves selecting a best response in each eventuality. How, though, can a best response be determined given the flaw in the policy evaluation process identified by Lucas? What Kydland and Prescott showed was that an optimal control approach to macroeconomic intervention could be consistent in the sense that policy makers were in each particular set of circumstances indeed selecting the best policy, but the economic performance thereby achieved could be suboptimal. The ultimate conclusion of their analysis is that governments should forgo the discretion to select optimal policies in favour of a set of rules for economic policy from which it would be hard to deviate. A rules-based approach answers the Lucas critique in that it absolves the government of both the opportunity and the obligation to pursue optimal plans that are time inconsistent.

Kydland and Prescott use the trade-off between inflation and unemployment as one illustration of their argument. A government that wishes to reduce inflation to some socially preferable lower rate could achieve its objective by an announced policy of monetary contraction. In the new classical view, if the policy is credible, agents will revise their inflationary expectations downwards and inflation will fall without any evident implications for the rate of unemployment. This is an optimal policy ‘given the current situation and a correct evaluation of the end of period position’ (Kydland and Prescott, 1977, p. 473). However, a new situation and new optimal policy that is also socially preferable now arises: if the government increases the rate of monetary growth – reneging on its previous commitment and creating a ‘monetary surprise’ – it may engineer a reduction in the rate of unemployment below the natural rate. Unfortunately, this is unsustainable as agents will again revise their inflationary expectations, upwards this time, and discount the surprise. The outcome is that the economy returns to the vicinity of its position prior to the first policy change; this is clearly suboptimal given the earlier achievement of a lower inflation rate and an unchanged rate of unemployment. However, there is one other crucial difference following the implementation of such time-inconsistent optimal plans: the government’s credibility will have been damaged and future monetary policy announcements are unlikely to be believed. Kydland and Prescott (1977, p. 481, emphases in original) are at pains to point out here that they are not charging governments with myopia – their actions are after all appropriate in each set of prevailing circumstances and, moreover, they are consistent with social preferences – rather the suboptimal outcome ‘arises because there is no mechanism to induce future policymakers to take into consideration the effects of their policy, via the expectations mechanism, upon current decisions of agents’. The mechanism they have in mind is the conduct of macroeconomic policy by rules, the point of which is to make macroeconomic governance both time consistent and optimal. In terms of the example, rules that focused on the attainment of a low and stable rate of inflation would be the equivalent of the implementation of the ‘first optimal’ policy without the possibility of any subsequent and damaging volte-face. Kydland and Prescott’s paper stimulated a large and influential literature, one of the practical results of which has been the embodiment of a rules-inspired approach in the institutional architecture of macroeconomic policy making – for example, in the increasing reliance on independent central banking arrangements in Europe and elsewhere (Nobel Foundation, 2004).

The second contribution for which Kydland and Prescott were awarded the Nobel Prize was their 1982 Econometrica paper, ‘Time to Build and Aggregate Fluctuations’. This offered new ways to conceptualise, model and interpret business cycles, and proved enormously influential: in the view of the Royal Swedish Academy of Sciences (2004, p. 25), it ‘transformed the academic research on business cycles’. Kydland and Prescott’s approach was to integrate what had for a long time been two rather distinct areas of study: growth theory and business cycle theory. Long-run economic growth had been interpreted largely as a supply-side reflection of technological change. On the other hand, short-run fluctuations around the longrun growth trend – the business cycle – were widely thought to be linked to changes in aggregate demand. The latter interpretation offered policy makers the opportunity to respond to business cycle fluctuations by manipulating aggregate demand. However, during the 1970s, the stable relationships between macroeconomic aggregates that gave rise, for example, to the Phillips curve had evidently broken down and issues around the business cycle were reopened to debate. As noted, Robert Lucas was an early contributor. As well as offering his critique of the traditional form of policy evaluation, Lucas also introduced a ‘monetary surprise’ explanation of the business cycle in which unanticipated changes in the money supply caused errors in agents’ price expectations and moved output and employment temporarily away from their natural levels. However, Lucas also recognised that, in its exclusive focus on economy-wide aggregates, macroeconomic theory as a whole was neglectful of the microeconomic structures, processes and decisions that ultimately underpin macroeconomic performance. In providing a new approach 336 to understanding business cycles, Kydland and Prescott’s 1982 paper also contributed new micro foundations to the study of macroeconomic phenomena.

Kydland and Prescott’s working hypothesis was that both longrun growth and the business cycles were driven by the same real force of technological change. A supply-side explanation of the business cycle was novel to economics after Keynes, but perhaps the paper’s most innovative characteristic was its explicit micro-theoretic foundation. Kydland and Prescott identified a link between technological change and fluctuations in output and employment that centred on the responses of rational agents, in their labour supply and consumption decisions, to the altered structure of relative prices prompted by a technology shock. A positive technology shock will raise productivity, real wages and labour demand, thereby directly (via a productivity effect), and indirectly (as a result of higher labour input) boosting output. In turn, some of this increased output will be consumed and the rest invested, the relevant proportions reflecting agents’ preferences and expectations (Royal Swedish Academy of Sciences, 2004). Kydland and Prescott used the Solow residual as a measure of the rate of technological progress and in a later paper (Kydland and Prescott, 1991a) found that about 70 per cent of the variance in US output in the post-1945 period could be accounted for by variations in the residual. One of the most notable implications of Kydland and Prescott’s 1982 paper has been the restoration of the view that in the matter of economic fluctuations, the supply side is important. Regardless of the economic perspective considered, their work demands that the microtheoretic components of the macroeconomic canvas are given explicit treatment.

Other notable work by Kydland includes, with Edward Prescott, further research on business cycles and a methodological discussion (Kydland and Prescott, 1991a; 1991b; 1996). Partly with David Backus and Patrick Kehoe, he has reflected on international business cycle questions (Kydland, 1992b; Backus et al., 1992a). With William Gavin, Kydland has done work on the neutrality of money (Gavin and Kydland, 1999), and with Paul Gomme and Peter Rupert he has introduced refinements to the real business cycle model (Kydland et al., 2001). Kydland (1995) has also edited a collection of essays on business cycle theory.

Main Published Works
(1977), ‘Rules Rather Than Discretion: The Inconsistency of Optimal Plans’ (with E.C. Prescott), Journal of Political Economy, 85, June, pp. 473–92.
(1982), ‘Time to Build and Aggregate Fluctuations’ (with E.C. Prescott), Econometrica, 50, November, pp. 1345–70.
(1991a), ‘Hours and Employment Variation in Business Cycle Theory’ (with E.C. Prescott), Economic Theory, 1, January, pp. 63–81.
(1991b), ‘The Econometrics of the General Equilibrium Approach to Business Cycles’ (with E.C. Prescott), Scandinavian Journal of Economics, 93 (2), pp. 161–78.
(1992a), ‘International Real Business Cycles’ (with D. Backus and P. Kehoe), Journal of Political Economy, 100, August, pp. 745–75.
(1992b), ‘On the Econometrics of World Business Cycles’, European Economic Review, 36 (2), pp. 476–82.
(1995), Business Cycle Theory (ed.), Aldershot, UK and Brookfield, US: Edward Elgar.
(1996), ‘The Computational Experiment: An Econometric Tool’ (with E.C. Prescott), Journal of Economic Perspectives, 10, Winter, pp. 69–85.
 (1999), ‘Endogenous Money Supply and the Business Cycle’ (with W. Gavin), Review of Economic Dynamics, 2, April, pp. 347–69.
(2001), ‘Home Production Meets Time to Build’ (with P. Gomme and P. Rupert), Journal of Political Economy, 109, October, pp. 1115–31.

Secondary Literature
Royal Swedish Academy of Sciences (2004), ‘Finn Kydland and Edward Prescott’s Contribution to Dynamic Macroeconomics: The Time Consistency of Economic Policy and the Driving Forces Behind Business Cycles’, available from http://nobelprize.org.
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