Part - I

Abstract

Individuals are better-off when the central bank's intentions are consistent and credible. If the central bank has the discretion to change its decisions frequently, then there will be more uncertainty regarding unemployment, inflation, interest rates, wages, etc. Research by Edward C. Prescott and Finn E. Kydland has led to a focus on how central banks can be strengthened and made more independent in order to minimize this time-inconsistency problem. Further, they turned Keynesian economics upside down by finding that business cycles were the result of shocks to the aggregate supply than to the aggregate demand.

The 2004 Nobel Prize in Economic Sciences was won by Edward C. Prescott and Finn E. Kydland for two papers they coauthored in the field of dynamic macroeconomics in the late 70s and early 80s. Prescott and Kydland's work has laid to rest the Keynesian macroeconomic theory, which assumed that unemployment and inflation were inversely related-the Phillips Curve. According to Keynes, monetary policy should be used to dampen business cycles and keep unemployment low. Managing aggregate demand was critical in an economy. The central bank of a country should pursue a loose monetary policy to counter periods of high unemployment. This would make borrowing cheaper and result in increased investment spending. The short-run output of the economy would increase, boosting employment.

The early 1970s saw both high inflation and unemployment in the United States - stagflation. This was not possible in the world of Keynesian economics. The efforts to fight inflation failed. The oil crisis and the subsequent worldwide recession magnified the problem. The Keynesian economic theory, which reigned between the Great Depression and the early 1970s, was under fire.

Robert Lucas, another Nobel Laureate, had already showed the fundamental inefficiencies of the Keynesian theory in what came to be known as the "Lucas Critique". Lucas argued that individual decisions are based on expectations of future profitability. These expectations depend on many things, including the current and expected future economic policies. These small individual decisions, in turn, have significant influence on the changes in the overall economy. Thus, policy makers need to incorporate these influences when estimating the effects of any policy change.

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* Contributed by -
Ravi Birhman, B.E. (Computer Science), BITS, Pilani,
Kshitij Goel, B.Tech. (Mechanical), IIT Guwahati,
Post Graduate Diploma in Management (First Year),
Indian Institute of Management, Calcutta.