The Transformation of Macroeconomic Policy and Research

By Prescott, Edward C. | American Economist, Spring 2006 | Go to article overview
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The Transformation of Macroeconomic Policy and Research

Prescott, Edward C., American Economist

1. Introduction

What I am going to describe for you is a revolution in macroeconomics, a transformation in methodology that has reshaped how we conduct our science. Prior to the transformation, macroeconomics was largely separate from the rest of economics. Indeed, some considered the study of macroeconomics fundamentally different and thought there was no hope of integrating macroeconomics with the rest of economics, that is, with neoclassical economics. Others held the view that neoclassical foundations for the empirically determined macro relations would in time be developed. Neither view proved correct.

Finn Kydland and I have been lucky to be a part of this revolution, and my address will focus heavily on our role in advancing this transformation. Now, all stories about transformation have three essential parts: the time prior to the key change, the transformative era, and the new period that has been impacted by the change. And that is the story I am going to tell: how macroeconomic policy and research changed as the result of the transformation of macroeconomics from constructing a system of equations of the national accounts to an investigation of dynamic stochastic economies.

Macroeconomics has progressed beyond the stage of searching for a theory to the stage of deriving the implications of theory. In this way, macroeconomics has become like the natural sciences. Unlike the natural sciences, though, macroeconomics involves people making decisions based upon what they think will happen, and what will happen depends upon what decisions they make. This means that the concept of equilibrium must be dynamic, and--as we shall see--this dynamism is at the core of modern macroeconomics.

Before proceeding, I want to emphasize that the methodology that transformed macroeconomics is applicable to the study of virtually all fields of economics. In fact, the meaning of the word macroeconomics has changed to refer to the tools being used rather than just to the study of business cycle fluctuations.

As a result of the transformation, these are exciting times in macroeconomics. The methodology that Finn and I developed for the study of business cycle fluctuations is being used to advance learning not only in the area of business cycles, but also in virtually all areas of economics. By using this methodology, researchers are able to apply theory and measurement to answer questions, define puzzles, and determine where better measurement is needed before specific questions can be answered.

Over the last five years, I have addressed the following questions using this methodology: What is the fundamental value of the stock market, and do fundamentals account for the large movements in the value of the stock market relative to gross domestic product that have occurred over time? Why did hours worked per adult fall by one-third in Western Europe, and not in Canada and the United States, in the 1970-1995 period? Why were market hours in the United States at the end of the 1990s 5 percent above what theory predicts? Why did Japan lose a decade of growth beginning in 1992, a decade when growth was at trend in the other advanced industrial countries?

Much of this recent research originates from my undergraduate teaching that began in the late 1990s. Until then, I had never taught a course in which macroeconomic questions were addressed using this methodology. The undergraduate course I taught was Quantitative Analysis of the Macroeconomy. I chose to teach this course because I felt there was a need to develop material that could be used in teaching what macroeconomics has become at the undergraduate level. I felt there was this need because Finn's and my work on the time consistency problem and developments in agency theory led me to the conclusion that having good macroeconomic policy requires having an educated citizenry that can evaluate macroeconomic policy. A second reason why I thought there was this need is that by introducing talented undergraduates to the excitement of modern macroeconomics, some would be influenced to pursue careers in economic research and would make important advances to economic science.

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