Kydland and Prescott: Economists

Finn Kydland and Ed Prescott are widely recognized as the intellectual leaders of the real business cycle approach to macroeconomics. They are leaders of a revolution in macroeconomic methodology and practice. Their work on time consistency and the theory and measurement of business cycles contributed directly to the rational expectations revolution. Their papers are required reading in most graduate courses in macroeconomics today.

Kydland and Prescott pioneered "quantitative theory," sometimes also known as "calibration" as an alternative to traditional methods of analyzing data in economics. Although originally controversial, this methodological approach is now widely used throughout the profession. This approach attempts to formulate theoretical models in terms of parameters that can be measured relatively easily; it focuses on estimation of parameters from data different than the data that is to be explained. This is an ambitious program of finding human behavioral constants that can be used to explain economic behavior in a wide variety of circumstances. In practice, one of the major focuses has been the reconciliation of cross-sectional and time series data, and the reconciliation of long-run time series behavior (growth) with short-run behavior (business cycles).

One paper stands out as the seminal contribution to to the real business cycle approach. Kydland and Prescott's "...Time to Build..." was an attempt to study the extent to which the business cycle can be explained as the ordinary working of a competitive economy subject to random technology shocks. It was written in 1982, when the foundational of dynamic macroeconomics had already been laid, and the next goal was to understand how to use the theory to study quantitative fluctuations. At that time growth theory was widely used to study both economic development and public finance. It was not widely believed that growth theory had much to say about macroeconomic issues. Kydland and Prescott developed practical methods for deriving the quantitative implications of growth theory for fluctuations. To everyone's surprise, business cycle fluctuations are just what that theory predicted. Prior to the "...Time to Build..." paper the elimination of the business cycle was widely viewed as the goal of economic policy; now it is widely understood that the issue is one of efficient fluctuation, not the absence of fluctuation. Moreover, the terms of the debate have changed. Research that challenges real business cycle has come to focus on explaining the technology shocks. One of the most significant advances in "...Time to Build..." is the insistence on explaining quantitative features of the data rather than merely the qualitative ones; this has now become the predominant theme in macroeconomic research. Whether calibration can replace econometrics as an empirical methodology is open to debate; whether the quality of theoretical research in macroeconomics has been enormously improved by changing focus from qualitative to quantitative analysis is not.

Kydland and Prescott are responsible for pioneering a second major area of economic research. When Robert Lucas received the Nobel Prize in economics, one of the major scientific achievements mentioned by the Swedish Academy is the "Lucas critique." Quoting from the Swedish Academy "The Lucas critique has had a profound influence on economic-policy recommendations. Shifts in economic policy often produce a completely different outcome if the agents adapt their expectations to the new policy stance." While influential, the Lucas critique only tells us how not to do economic analysis. The idea of time consistency, developed by Kydland and Prescott in "Rules rather than Discretion..." focuses instead on the strategic idea that policies that yield short-term benefits that are negated in the future by changes in expectations. This idea leads to the positive research program of focusing on such issues as the credibility of commitments and institutional arrangements such a independent central banks that make make commitments credible. The idea of time consistency now play a critical role in much of international economics, public finance, and political economy.