Nobel Winners Revive Keynesian Economics with Microfoundations

This article originally appeared in the Planet Money newsletter. On a recent Monday, economists globally awaited news from the Royal Swedish Academy of Sciences to see who received this year’s Nobel Prize in economics. The prize went to Robert Hall of Stanford University and Michael Woodford of Columbia University, recognized “for microeconomic foundations of macroeconomic stabilization.”

Timo Boppart, an economist at Stockholm University and part of the prize committee, explained the award’s significance with an ice cream menu as a demonstration. He highlighted how firms set prices not continuously but for whole seasons, capturing an essential economic concept known as “sticky prices.” This principle suggests that prices remain stubbornly constant despite changing economic conditions, impacting the broader economy significantly.

The Background on Sticky Prices and Keynesian Economics

Sticky prices are central to New Keynesian economics, a framework that redefined macroeconomic theory, influencing how policymakers approach recessions and inflation. Hall and Woodford’s contributions helped revive the work of John Maynard Keynes, a major economist whose ideas risked obscurity during economic challenges in the 1970s.

Keynes, known as a founding figure of macroeconomics, argued during the Great Depression that economies could endure long-term slumps without government intervention. His seminal work, “The General Theory of Employment, Interest, and Money,” proposed that government action was necessary to boost spending and employment.

Keynesian economics emphasized government roles in managing economic cycles, gaining widespread acceptance temporarily. Even free-market advocate Milton Friedman once acknowledged the influence of Keynesian thought, albeit with some reservations.

Challenges and Evolution of Keynesian Economics

In the 1970s, Keynesian models faced scrutiny with the advent of stagflation, where inflation and unemployment rose simultaneously, challenging existing theories. Economists like Robert Lucas and Edward Prescott, who also received Nobel recognition, criticized the reliance on historical patterns without understanding the individual decisions underlying these models.

To address these critiques, new models were developed with “microfoundations,” emphasizing individual decisions to understand economic trends better. Real Business Cycle theory emerged as an alternative, assuming flexible prices and wages adjusted freely, leaving minimal scope for government intervention during economic downturns.

Economist Gregory Mankiw recounted how the debate over these models unfolded during his time at MIT with Michael Woodford. Skepticism towards abandoning Keynesian perspectives led to efforts by Hall, Woodford, and others to refine and rebuild these theories without discarding Keynesian insights.

Rebuilding with New Keynesian Insights

Hall and Woodford focused on rebuilding macroeconomic theories by integrating individual spending decisions and sticky prices. Sticky prices, as demonstrated with ice cream, impact wage adjustments, suggesting significant consequences for the economy.

For instance, during recessions, sticky wages and prices prevent quick adjustments, resulting in reduced production and employment. This theory supports the idea that policy interventions are necessary because market mechanisms alone are inadequate in certain economic situations.

New Keynesian economics preserved the value of Keynes’ insights, addressing criticisms of earlier models, and adapting these theories to situational demands. Woodford’s work on concepts like “forward guidance” influenced Federal Reserve strategies, aiming to manage economic conditions effectively.

Mankiw noted the broad acceptance of New Keynesian ideas among modern economists, marking a return of Keynesian concepts grounded in individual decision-making. As economists and central banks navigate economic challenges today, these evolved models continue to inform policy decisions.