How are GDP and inflation affected by a temporary increase in the interest rate or a tax cut? What happens if a central bank makes a permanent change in its inflation target or a government modifies its objective for budgetary balance?
Thomas J Sargent and Christopher A Sims have developed methods for answering these and many other questions regarding the causal relationship between economic policy and different macroeconomic variables such as GDP, inflation, employment and investments.
The economy is constantly affected by unanticipated events. The price of oil rises unexpectedly, the central bank sets an interest rate unforeseen by borrowers and lenders, or household consumption suddenly declines. Such unexpected occurrences are usually called shocks. The economy is also affected by more long-run changes, such as a shift in monetary policy towards stricter disinflationary measures or fiscal policy with more stringent budget rules. One of the main tasks of macroeconomic research is to comprehend how both shocks and systematic policy shifts affect macroeconomic variables in the short and long run.
What happens if a central bank is instead given a mandate to maintain inflation close to two per cent?
Sargent’s analysis deals with the effects of such systematic policy rules and the consequences of changes in the rules for policy. Expectations are an integral part of this analytical approach.
In his article “Macroeconomics and Reality” (1980), Sims introduced a new way of analysing macroeconomic data. He also concurred with Sargent in emphasising the importance of expectations.
The questions which the laureates have dealt with are obviously interrelated. Although Sargent and Sims have carried out their research independently, their contributions are complementary in many ways.
Sims shared Sargent’s criticism of the large macroeconometric models which were earlier used by researchers, central banks and ministries of finance.
Owing to the scientific contributions of Sargent and Sims, research in macroeconomics and analysis of economic policy have advanced substantially. Their combined work constitutes a solid foundation for modern macroeconomic analysis. It is hard to envisage Tuesday’s research without this foundation.
Today, the directions of research that were inspired by Sargent’s and Sims’s contributions have much in common.
The empirical strategies proposed by Sargent and Sims are intercomparable. Researchers have a choice of method depending on the application. With detailed knowledge about the structure of the economy, Sargent’s method may be preferable, in particular since it allows a counterfactual analysis of systematic changes in economic policy. When knowledge of the field is less exact, Sims’s method may be safer. Owing to the scientific contributions of Sargent and Sims, research in macroeconomics and analysis of economic policy have advanced substantially. Their combined work constitutes a solid foundation for modern macroeconomic analysis. It is hard to envisage Tuesday’s research without this foundation.
The Royal Swedish Academy of Sciences
