The transformation of macroeconomic policy and research prize Lecture, December 8, 2004 by

Finn and I had read the Lucas critique and knew that for dynamic equilib-

rium models, only policy rules could be evaluated. This led us to search for a

best rule to follow, where a rule specifies policy actions as a function of the

state or position of the economy. We had worked on this problem before

Finn left Carnegie Mellon to join the faculty of the Norwegian School of

Business and Economics in 1973. In academic year 1974–1975 I visited the

Norwegian School of Business and Economics, and in the spring of 1975 Finn

and I returned to this problem. This is when we wrote our paper “Rules

Rather than Discretion: The Inconsistency of Optimal Plans,” one of the two

papers for which Finn and I were awarded the Nobel Prize.

In previous research we had considered time-consistent stationary policy

rules. These rules have the property that they are a fixed point of the mapping

that specifies the best rule today as a function of the rule that will be used in

the future. The fact that these rules were not optimal led us to our key 

insight: the best event-contingent policy plan is not time-consistent. By this I

mean the continuation of a plan is not optimal at some future point in the

event-time tree. For example, it is always best to tax the returns on existing 

capital but not tax the returns on new investments. The reason is that a tax on

existing capital is a lump-sum tax and there is no associated distortion, whereas

any taxes on future returns of current investments are distortionary. But 

capital investments today become existing capital tomorrow, and tomorrow

the best policy action is to tax their returns.

This leads to the conclusion that being able to commit has value and that

having discretion has costs. The only method of commitment is to follow rules.

That is why we concluded that the time inconsistency of optimal plans necessi-

tates following rules. Some societies have had considerable success in following

good, but time-inconsistent, policy rules, and as a result their citizens enjoy a

higher standard of living. Other societies have limited success in this regard,

and as a result their citizens suffer economic hardships.

This need for rules in organizational settings has long been recognized.

That is why all agree that rule by a good set of laws is desirable. Rule by law is

a political institution to get around the time consistency problem. What was

new in our research was that this principle holds for macroeconomic policy

counter to what everyone thought at the time.

A Success in Following a Good Monetary Policy Rule

A notable example of a success in following a good, but time-inconsistent, rule

is the one maintaining a low and stable inflation rate. Before describing an

institution that is proving effective in getting commitment to this good rule in

many countries, I will first describe one reason why the price stability policy

rule is time-inconsistent.

Consider an economy in which the nominal wage rate is set above the market

clearing level in some sectors, given the inflation rate specified by the rule. This

outcome could be the result of industry insiders in each of a number of 

industries finding this action in their best interest, given the wages chosen by the

insiders in other industries and the expected inflation rate. If the price stability

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policy rule is followed, ex post a distortion occurs that results in low employment.

This distortion can be reduced by having inflation in excess of the amount spec-

ified by the rule. With the time-consistent monetary policy rule, inflation will be

at that level where the marginal value of higher inflation in reducing the distor-

tion will just equal the marginal cost of the higher inflation. The equilibrium

outcome is high inflation and no reduction in the distortion. Commitment to

the best rule will not result in high inflation, just the labor market distortion.

I turn now to an institution that is proving successful in sustaining this rule:

an independent central bank. Members of this organization have a vested

interest in following this rule, for if it is not followed, they would incur the

risk that they would suffer in the future. If inflation has been excessive and a

new administration is elected, people in the organization will be replaced

and the size of the central bank cut. Thus, members of this organization have a

vested interest in the rule being followed.

The increased stability of the economy and the improved performance of

the payment and credit system may be due in part to the diffusion of findings

of Finn’s and my “Rules Rather than Discretion” paper. People now recognize

much better the importance of having good macroeconomic institutions

such as an independent central bank.

To find the time-consistent policy we de facto considered a game. In the 

simplest case, the value function of an individual is v(k,K) and that of the policy

maker v(K,K), where k is a given individual’s capital stock and K is the capital

stock of all others. Note that within the class of policies that treat individuals

anonymously, all individuals order policies in the same way as does the policy

maker. At the first stage of each period, the policy maker selects the policy

that is best for the representative individual and the rule by which policy will

be selected in the future.

3. THE TRANSFORMATION OF MACROECONOMIC RESEARCH

The title of this address is “The Transformation of Macroeconomic Policy

and Research.” I turn now to the research part of the title. The methods used

in macroeconomic research were different prior to Finn’s and my paper,

“Time to Build and Aggregate Fluctuations” (1982). The new methodology

was developed in the summer of 1980 when Finn and I did the research and

wrote the first draft of our “Time to Build” paper. We also wrote the first draft

of this paper that summer.

Before specifying the new research methodology, I have to discuss what the

key business cycle facts are and why they led economists to falsely conclude

that business cycle fluctuations were not in large part equilibrium responses

to real shocks. Then I will specify the methodology that Finn and I developed

and used to quantitatively determine the consequences of these shocks for

business cycle fluctuations.

I emphasize that what is important is the methodology and that this 

methodology can be and has been used to quantitatively determine the 

consequences of both nominal and real shocks. By using these methods, the

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