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1 0 OCTOBE R 2011

Scientific Background on the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2011

compiled by the Economic Sciences Prize Committee of the Royal Swedish Academy of Sciences

THE ROYAL SWEDISH ACADEMY OF SCIENCES has as its aim to promote the sciences and strengthen their influence in society. BOX 50005(LILLA FRESCATIVÄGEN 4 A), SE-104 05 STOCKHOLM, SWEDEN TEL +46 8 673 95 00, FAX +46 8 15 56 70, INFO@KVA.SE  HTTP : //KVA.SE

Empirical Macroeconomics
Thomas J. Sargent and Christopher A. Sims
One of the main tasks for macroeconomists is to explain how macroeconomic aggregates – such as GDP, investment, unemployment, and in‡ ation –behave over time. How are these variables a¤ected byeconomic policy and by changes in the economic environment? A primary aspect in this analysis is the role of the central bank and its ability to in‡ uence the economy. How e¤ective can monetary policy be in stabilizing unwanted ‡ uctuations in macroeconomic aggregates? How e¤ective has it been historically? Similar questions can be raised about …scal policy. Thomas J. Sargent and Christopher A. Sims havedeveloped empirical methods that can answer these kinds of questions. This year’ prize recognizes these methods and their successful s application to the interplay between monetary and …scal policy and economic activity. In any empirical economic analysis based on observational data, it is di¢ cult to disentangle cause and e¤ect. This becomes especially cumbersome in macroeconomic policy analysisdue to an important stumbling block: the key role of expectations. Economic decision-makers form expectations about policy, thereby linking economic activity to future policy. Was an observed change in policy an independent event? Were the subsequent changes in economic activity a causal reaction to this policy change? Or did causality run in the opposite direction, such that expectations ofchanges in economic activity triggered the observed change in policy? Alternative interpretations of the interplay between expectations and economic activity might lead to very di¤erent policy conclusions. The methods developed by Sargent and Sims tackle these di¢ culties in di¤erent, and complementary, ways. They have become standard tools in the research community and are commonly used to informpolicymaking. Background Prior to the 1970s, expectations played, at best, a rudimentary role in the analysis of macroeconomic outcomes. Following the seminal work by Milton Friedman, Robert Lucas, Edmund Phelps, and others, it became necessary to systematically incorporate expectations not only into macroeconomic theory, but also –and more importantly –into its empirical implementation. This was amajor obstacle, however. At the time, formal methods were simply not available to identify and analyze exogenous shocks, 1

as a means of evaluating macroeconomic theories that feature “active” formation of expectations. Sargent and Sims have both made seminal contributions that allow researchers to specify, empirically implement, and evaluate dynamic models of the macroeconomy with a centralrole for expectations. Their subsequent work, from the initial papers until today, has delivered many extensions, re…nements, and powerful applications. The contributions by Sargent and Sims have generated literatures of methodological research and applied studies within the research community as well as the policymaking community. Prior to the formative research by Sargent and Sims, the predominantempirical method in macroeconomics was to statistically estimate a large linear system, typically built around the Keynesian macroeconomic model. This estimated system was then used to interpret macroeconomic time series, to forecast the economy, and to conduct policy experiments. Such large models were seemingly successful in accounting for historical data. However, during the 1970s most...
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