Nobel Economiaaa

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INFORMATION FOR THE PUBLIC

The art of distinguishing between cause and effect in the macroeconomy
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?This year’s Laureates in economic sciences, 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 longrun 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 macroeconomicresearch is to comprehend how both shocks and systematic policy shifts affect macroeconomic variables in the short and long run. Sargent’s and Sims’s awarded research contributions have been indispensable to this work. Sargent has primarily helped us understand the effects of systematic policy shifts, while Sims has focused on how shocks spread throughout the economy.

Two-way relationships andprevailing expectations
One difficulty in attempting to understand how the economy works is that the relationships are often reciprocal. Is it policy that influences economic development or is there a reverse causal relationship? One reason for this ambiguity is that both private and public agents actively look ahead. The expectations of the private sector regarding future policy affect today’sdecisions about wages, prices and investments, while economic-policy decisions are guided by expectations about developments in the private sector.

Investors base their decisions on expectations about future economic policy.

Central banks set the interest rate based on expectations about private sector developments.

A clear-cut example of a two-way relationship is the economic development inthe early 1980s, when many countries shifted their policy in order to combat inflation. This change was primarily a reaction to economic events during the 1970s, when the inflation rate increased due to higher oil prices and lower productivity growth. Consequently, it is difficult to determine whether the subsequent changes in the economy depended on the policy shift or on underlying factors beyondthe control of monetary and fiscal policy which, in turn, gave rise to a different policy. One way of studying the effects of economic policy would be to carry out controlled experiments. In practice, however, varying policies cannot be randomly assigned to different countries. Macroeconomic research is therefore obliged to use historical data. The laureates’ foremost contribution has been toshow that causal macroeconomic relationships can indeed be analyzed using historical data, even in cases with two-way relationships. There are good reasons to believe that unexpected shifts in economic policy may have other effects than anticipated changes. It is not trivial, however, to distinguish between the outcomes of expected and unexpected policy. A change in the interest rate or tax rate isnot the same as a shock, in the sense that at least part of the change might be expected. This is a longstanding insight in the context of the stock market. A firm which reports improved earnings and higher forecasted profits might still encounter a drop in its share price, simply because the market expected an even stronger report. Moreover, the effects of an unanticipated policy shift might...