The macro-micro Nobel in economics

A very consequential award for economic policy and people's lives

When I landed in Palo Alto, California, in September 1978 to start a PhD programme at Stanford University, there was a buzz about Robert Hall’s paper in the Journal of Political Economy on the Life-Cycle Permanent Income Hypothesis.1

 Bob, as he was called, was a dashing young Stanford professor with a sports car bearing TSP on its number plate, named for the Time Series Processor computer program he created when he was a graduate student at the Massachusetts Institute of Technology. Along with Michael Woodford of Columbia University, he was awarded the Nobel Prize for economics this year for the body of work they started called the micro foundations of macroeconomic stabilisation.

 Bob’s paper showed consumption depended not on current income but on expected permanent income, and , therefore, only unexpected and permanent changes in policy could affect the path of consumption and employment. This fundamental insight was central to the New Keynesian models developed thereafter.

In 1978, the world was still recovering from the 1973-74 oil shock, which had created a new phenomenon called stagflation — high inflation coexisting with high unemployment. Existing models could not explain stagflation, as prices and wages were assumed to adjust to equilibrate markets and remove unemployment. Subsequently a bevy of economists — Guillermo Calvo, Stanley Fischer, Michael Bruno, Olivier Blanchard, Ben Bernanke (Nobel Prize winner, who also taught me macroeconomics at Stanford in 1980), Joseph Stiglitz and George Akerlof — developed models that introduced wage and price rigidities, information asymmetries and credit market imperfections to explain stagflation and brought back a role for fiscal policy, which monetarists like Milton Friedman and Edward C Prescott (both Nobel winners) had earlier dismissed as inconsequential for smoothing consumption.

 Michael Woodford synthesised all this work in his now famous book Interest and Prices, where he presented the basic structure of the New Keynesian macroeconomics built using microeconomic insights into consumer and firm behaviour on how price expectations are formed, prices and wages are set, and how central bankers and tax policy can influence that behaviour. John Taylor, also at Stanford, could have been added to the Prize as his famous Taylor rule is also central to the New Keynesian framework synthesised by Dr Woodford.

 The insights from the New Keynesian framework have been hugely influential. Federal Reserve Chair Ben Bernanke used it after the 2008 financial crisis to help the United States recover, although, in my humble opinion, he may have gone too far with quantitative easing (QE), whereby the central bank starts buying financial assets once policy interest rates have dropped to near zero. His third and fourth waves of QE had marginal benefits.

 It has again been extremely helpful more recently in Fed Chair Jerome Powell’s handling of the recovery from the Covid pandemic, when he was accused initially of misdiagnosing inflation as temporary but subsequently managed to contain inflation without causing a recession. Donald Trump’s tariffs and misguided war in Iran have stoked inflation and not allowed Mr Powell to finish the job. His successor Kevin Warsh has inexplicably dropped forward guidance from his tool kit and may have made his job harder.

 I was fortunate to interact with some of the contributors to this edifice. I worked closely with Stanley Fischer when he was chief economist at the World Bank, and we co-edited a pioneering book on African economics. Michael Bruno, another chief economist, asked me to lead the seminal World Development Report 1997 on the role of the state, which emphasised the importance of an effective state and regulation. After he passed away unexpectedly, we finished that Report under the next chief economist, Nobel laureate Joseph Stiglitz.

 But these great minds did not always agree. Stanley Fischer went on to hold key positions at the International Monetary Fund, but surprisingly initially supported harsh fiscal policy, which exacerbated the Asian Financial Crisis, something quite contrary to what the New Keynesian framework would have suggested. Joe Stiglitz was a harsh critic of those policies and of premature liberalisation of capital accounts, which had created the Asian financial crisis.

 New Keynesian frameworks have, no doubt, helped design better stabilisation policies in the developed world, as the Nobel committee suggests. But these policies have also had huge spillovers, which make macro-management in developing countries more difficult, both when the stimulus is introduced and when it is withdrawn. Money flows in, making exchange rate management and monetary policy more complicated, and the reverse happens when money suddenly flows out. But that does not in any way detract from the magnificent work done by our two current Nobel Prize winners and the spillovers must, in any case, be dealt with separately.

 The New Keynesian framework was not helpful in a developing country’s context because the information and financial depth needed for a permanent income hypothesis to be relevant do not exist. Unlike in the developed world, a very sizeable percentage live hand-to-mouth, so traditional Keynesian approach to stimulate demand works. In addition, with large informal markets and generalised under-employment, the concept of an output gap — the difference between actual and potential output — central to the New Keynesian framework is not valid for a developing country. Nevertheless, some studies have found the New Keynesian models with forward expectations and an output gap valid and others have not.

 In my own recent work on India’s inflation, I did not find the output gap helpful. But I also find the structural school of inflation, which ignores monetary policy and expectations, incomplete, as it cannot explain what generates broader inflation. Instead, I find that a variable mark-up pricing (not Michael Bruno’s fixed mark-up model) with a hybrid monetarist-structural approach2 fits well with India’s reality. As India’s economy develops, becomes more formal and gains financial depth, tools developed by the New Keynesian framework may become more relevant.

 Meanwhile, going back to the Nobel Prize I am so happy that a micro-macro approach to understanding how economies behave has been recognised. Macroeconomists and microeconomists typically do not talk to each other, but here is evidence of why they should. Dr Hall was famous for saying, “Macroeconomics is just applied microeconomics.” This year’s Nobel winners — Hall and Woodford — follow theoretical insights with hard-core empirical work. No armchair theorising here, but consequential frameworks that improve policies and people’s lives. 

 

The writer is distinguished visiting scholar,

Institute for International Economic Policy,

George Washington University

1. Stochastic-JPE-Dec-1978.pdf

2. A Variable Mark-up Model of Inflation in India