Robert E. Hall of Stanford University and Michael Woodford of Columbia University, this year's Nobel economics laureates, are credited with reshaping the framework of modern macroeconomics by explaining movements in the broader economy through analysis of how households and firms behave. Their work led to the development of New Keynesian models that analyze and quantify the effects of monetary and fiscal policy in response to recessions and surging prices.
The Royal Swedish Academy of Sciences said on the 12th that "their work brought about a paradigm shift in the theory of economic stabilization policy," noting that New Keynesian models are used by central banks and governments around the world in setting policy. The academy said the research has contributed to designing policies that respond to economic shocks such as recessions and inflation.
After the Great Depression of the 1930s, Keynesian thinking placed weight on using fiscal and monetary policy to manage the business cycle. But the limits of existing models were exposed during the 1970s oil shocks, when stagflation brought recession and surging prices at the same time. Macroeconomic models of the era did not adequately explain the behavior of individual households and firms.
Hall and Woodford developed a new approach that analyzes the macroeconomy starting from how consumers decide their spending and how firms set prices for their goods. The aim was to explain, on the basis of choices made by individual economic agents, how changes in interest rates or government spending affect consumption, production and prices.
Hall combined Milton Friedman's permanent income hypothesis with rational expectations theory, advancing the random walk hypothesis of consumption in a 1978 paper. If information about future income is already reflected in current consumption, future changes in consumption are difficult to predict from existing information alone. An anticipated pay raise is factored into spending plans in advance, but an unexpected promotion or job loss can change consumption anew. This became the theoretical foundation for analyzing how much tax cuts or subsidy payments translate into higher consumption, because a temporary increase in income and an increase expected to persist over the long term can affect consumption differently. The Nobel committee said his work transformed theoretical and empirical research on consumption. Hall also explained the relationship between asset prices, investment and employment after the global financial crisis at a Bank of Korea international conference in June 2018.
Woodford focused on how firms set prices. Firms do not immediately change the prices of their goods even when raw material costs rise. Woodford built into his models the price stickiness under which firms form expectations about future economic conditions yet cannot freely adjust prices. This became the basis for explaining how changes in interest rates and demand affect not only prices but also production and employment. It means that when prices do not adjust immediately, firms may cut output and hiring first as demand weakens.
In his landmark 2003 book "Interest and Prices," Woodford systematized a theory for analyzing business cycles and the effects of stabilization policy. He is credited with establishing the theoretical foundation of modern monetary policy, which manages prices and the economy through adjustments to interest rates rather than the money supply. The Nobel committee said the book has had an enormous influence on the field of economics.
Woodford's research showed that a central bank's communication of its future policy direction to markets can itself be an important monetary policy tool, because households and firms factor expectations for future interest rates into current consumption and investment. If a central bank sends a credible signal that it will keep rates low, it can influence economic activity without actually cutting rates. This is connected to the theoretical basis for forward guidance. After the announcement of the prize, Woodford said it was a tremendous honor and that while he had not expected it, he was very pleased.
Yoon Tack, an emeritus professor of economics at Seoul National University who studied under Woodford, said in a telephone interview with The Seoul Economic Daily that "my mentor's contribution was in establishing that price stability does not end with price stability alone but can also contribute to the efficient running of the real economy." Recounting an anecdote in which Robert Lucas, the 1995 Nobel economics laureate, introduced a young Woodford as a "genius," he added, "He should have received it long ago, so it feels a bit late."
Lee Jae-won, a professor of economics at Seoul National University and a former head of the Bank of Korea Economic Research Institute, described taking Woodford's class while at Princeton University and called him "a scholar who established the model that forms the basis of modern monetary policy." He noted that Woodford's research on government debt, inflation and the relationship between fiscal and monetary policy is drawing renewed attention amid the recent rise in public debt worldwide and instability in sovereign bond yields.
Joo Won, head of the research division at Hyundai Research Institute, said: "I suspect the Nobel economics selection committee was also emphasizing how the importance of central banks has grown since COVID-19, with prices jumping and events such as the war in Ukraine. There is also a sense of lending weight to the role and policy authority of central banks, such as raising rates to rein in prices."