Monday, October 11, 2004

And the Winners Are...

Kydland and Prescott get this year's Nobel Prize for Economics (technically, the "The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel"), for their work on Real Business Cycle theory. Basically, RBC theory tries to explain fluctuations over the business cycle - cycles of moderate booms and busts- without resorting to nominal rigidities, or "stickyness" in wage and prices. Microeconomics 101 tells us that if there are more people looking for jobs than there are jobs at the current prevailing market, then the wage will be driven downward until supply=demand. However, during recessions that adjustment process doesn't seem to happen very fast -- wages don't fall and it appears that there is at least some "involuntary unemployment" - that is, people who are willing to work at the prevailing wage rate who are unable to obtain a job. So, the economy is operating at less then full employment, giving us reduced output.

K&P's work provide an alternative explanation, which is that much of the causes of booms and bust are actually due to people simply choosing to voluntarily opt-in or out of the labor force depending on current economic conditions. The idea being that if there's some "negative shock" to the economy, something which causes wages to fall relative to the average then people engage in "intertemporal substitution of labor." They say - well, wages suck this year so I may as well spend some time writing a novel or raising a kid or whatever, and I bet wages will go up again next year, so it makes sense to work less now and work more later when I'll get paid more for it. So, this type of unemployment is voluntary, in that people can get jobs at the prevailing market wage rate, but choose not to.

The effect of this is that relatively small shocks to the economy can be amplified - wages fall for some reason, then people leave the labor force, then people have less money to spend, demand for goods falls, wages fall some more, even more people leave the labor force, etc..etc... Tell story in reverse during boom times.

...and, if I bothered to read the press release I'd have noticed that they also got the prize for their (more interesting IMHO) work on time consistency and monetary policy. Short version: for good monetary policy to work, it's necessary for people to believe that you're going to engage in good monetary policy.