Economy

November, 2004

Economy & Policy

Nobel Prize for Advisors of Policy Consistency

Finn E. Kydland

Finn Kidland of Norway and Edward Prescott of USA jointly won this year’s Nobel Prize for Economics for their research that integrates the theory of business cycles with the theory of economic growth.

In its citation, the Royal Swedish Academy of Sciences that announces the Nobel Prize winners in Economics recognized Kydland and Prescott for their fundamental contributions to two closely related areas of macroeconomic research. The first concerns the design of macroeconomic policy. Under this “Kydland and Prescott uncovered inherent imperfections–credibility problems–in the ability of governments to implement desirable economic policies,” as the Academy put it. The second area concerns business cycle fluctuations, and the Academy said, “Kydland and Prescott demonstrated how variations in technological development–the main source of long-run economic growth–can lead to short-run fluctuations. In so doing, they offered a new and operational paradigm for macroeconomic analysis based on microeconomic foundations.”

The award-winning contributions by Kydland and Prescott appeared in two joint articles. Their 1977 research presented under the title “Rules Rather than Discretion: The Inconsistency of Optimal Plans”, described how policy makers often have an effect opposite to that intended because they lack consistency – for example, setting out to keep prices stable but in fact creating inflation.

The next article “Time to Build and Aggregate Fluctuations” (1982) proposed a theory of business cycles that differed much from Keynesian tradition.

While Prescott is a Professor in Arizona State University and Senior Advisor to Federal Reserve bank of Minneapolis, Kidland is a Professor at Carnegie-Mellon University in Pittsburgh, Pennsylvania and University of California in Santa Barbara.

Besides Kidland and Prescott, other favourite tipped for the prize was Robert Barro of Harvard University, who has studied why different countries grow at different rates and concluded that education and health were the keys.

Other bets included Princeton University's Paul Krugman and Harvard's Elhanan Helpman who worked on imperfect competition in international trade. Their theory explains why, for example, government subsidies for some aircraft manufacturers make sense from the consumer's standpoint, as they help fight monopolies.

Also Oliver Williamson of Berkley University and Olive Hart of Harvard were ranked high on the list of favourites for "contract theory" which explained why people organize themselves in companies for some jobs and in markets for others.

New Macroeconomics
Synopsis of two works by this year’s winner of Nobel Prize in Economics

In their 1977 article on “Time Inconsistency,” Finn Kidland and Edward Prescott studied the sequential choice of policies, such as tax rates or monetary policy instruments. The key insight is that many policy decisions are subject to a fundamental time consistency problem. Consider a rational and forward-looking government that chooses a time plan for policy in order to maximize the well-being of its citizens. Kydland and Prescott show that if given an opportunity to re-optimize and change its plan at a later date, the government will generally do so. What is striking about this result is that it is not rooted in conflicting objectives between the government and its citizens, nor is it due to the ability of unrestricted policymakers to react to unforeseen shocks. The result, instead, is simply a problematic logical implication of rational dynamic policymaking when private-sector expectations place restrictions on the policy decisions.

A significant upshot is that governments unable to make binding commitments regarding future policies will encounter a credibility problem. Specifically, the public will realize that future government policy will not necessarily coincide with the announced policy, unless the plan already encompasses the incentives for future policy change. In other words, sequential policymaking faces a credibility constraint. In mathematical terms, optimal policy decisions cannot be analyzed solely by means of control theory (i.e., dynamic optimization theory). Instead they should be studied as the outcome of a game, where current and future policymakers are modeled as distinct players. In this game, each player has to anticipate the reaction of future players to current play.

They analyzed general policy games as well as specific games of monetary and fiscal policymaking. They showed that the outcome in a rational-expectations equilibrium where the government cannot commit to policy in advance discretionary policymaking results in lower welfare than the outcome in an equilibrium where the government can commit.

Kydland and Prescott’s 1977 article had a far-reaching impact not only on theoretical policy analysis. It also provided a new perspective on actual policy experience, such as the stagflation problem. The analysis showed that a sustained high rate of inflation may not be the consequence of irrational policy decisions; it might simply reflect an inability of policymakers to commit to monetary policy. This insight shifted the focus of policy analysis from the study of individual policy decisions to the design of institutions that mitigate the time consistency problem. The result was the effort across the world to grant greater autonomy to the central banks from government control.

The next work by the duo presented under the title “Time to Build and Aggregate Fluctuations” (1982) proposed a theory of business cycle fluctuations far from the Keynesian tradition. In this article, Kydland and Prescott integrated the analyses of long-run economic growth and short-run macroeconomic fluctuations, by maintaining that a crucial determinant of long-run living standards, i.e., growth in technology, can also generate short-run cycles. Moreover, rather than emphasizing the inability of markets to coordinate supply and demand, Kydland and Prescott’s business cycle model relied on standard microeconomic mechanisms whereby prices, wages, and interest rates enable markets to clear. They thus argued that periods of temporarily low output growth need not be a result of market failures, but could simply follow from temporarily slow improvements in production technologies.

Kydland and Prescott showed that many qualitative features of actual business cycles, such as the co-movements of central macroeconomic variables and their relative variabilities, can be generated by a model based on supply (technology) shocks. Using fluctuations in technology growth of the same magnitude as those measured from data, Kydland and Prescott also demonstrated that their simple model could generate quantitatively significant cycles. It thus appeared that technology shocks should be taken seriously as a cause of business cycles.

From a methodological point of view, Kydland and Prescott’s article answered the call by Robert Lucas (winner of Economics Noble in 1995) for an alternative to the Keynesian paradigm. It was the first study to characterize the general equilibrium of a full-fledged dynamic and stochastic macroeconomic model based on microeconomic foundations. This required solving a set of interrelated dynamic optimization problems, where consumers and firms make decisions based on current and expected future paths for prices and policy variables, and where the equilibrium price sequences are such that private-sector decisions are consistent with clearing markets at all points in time and all states of the world. Kydland and Prescott showed that this challenging analysis could be carried out in practice by extensive use of numerical methods. Their empirical approach relied on model simulation, based on so-called “calibration”, and on comparing the synthetic data from simulations with actual data. Such calibration can be regarded as a simple form of estimation, where model parameters are assigned values so as to match the model’s long-run macroeconomic features with those in the data and render the behavior of individual agents in the model consistent with empirical microeconomic studies.

(Excerpts from citation by Swedish Academy of Sciences)

Currency & Money

US Dollar:

While this update goes to press, uncertainties over the US presidential elections would be over but the question is would this help the US dollar? A result in favor of Bush would help a rally in stocks and a Kerry win could help the bonds on a better fiscal outlook. All election uncertainties and outcomes could help the US dollar temporarily but markets look to fundamentals for any direction on the currency which would however have pressure on the US dollar. We expect the US external deficit to touch $600 billion this year from $503 billion at the end of 2003.

Japanese Yen:

We expect a stronger Yen in near term and the current trading levels are stronger than what we had seen few weeks back. Japan’s economy won’t boom but the current conditions suggest that economy would remain at its best for another 5-10 years to come. Corporate earnings are at its best suggesting further capacity expansion and leading to fall in rate of unemployment. The matter of concern is only oil but the pressure due from higher oil prices is expected to fade away soon as we are observing some stability in oil prices at levels below $50 per barrel, thus driving the economy to the fullest mode. We expect Japanese Yen to be trading at 104 levels in near term.

Euro:

Euro Zone economic upswing should be solid and exports have been the main driver behind this upswing. Federal Reserve is close to pause in the tightening cycle whereas European central banks are close to starting of tightening process which is guided by fundamentals of the economy and we expect rates to start moving upwards as soon as 2005 sets in and this would narrow yield gap thus making policy makers more tolerant towards a stronger Euro. We expect Euro to trade around 1.30 in near term but before becoming strong we might observe slightly lower trading levels between 1.2650- 1.2600.

Sterling:

No fundamentals behind its rise in recent days. The only factor is US dollar weakness which is driving a slow appreciation of the British pound. The advantage of high yielding currency would also fade as rates start to rise elsewhere leaving this currency vulnerable to more weakness. We expect the British pound to trade around 1.79 levels soon as housing market is stagnant with little demand and interest rate appears to be remaining unchanged until mid 2005.

Australian Dollar:

In the current scenario, a favorite pair which has broken all levels is AUD/USD. The pair has been totally guided by China demand. With better outlook on Chinese economy, strong commodity prices, we see no weakness in the pair in near term, however slower growth within the economy and rising interest rates around the world may have a negative impact on the currency. We expect the pair to be at current levels and see an appreciation towards 0.7500-0.7550 cents against the US dollar.

Indian Rupee:

The negative concerns on the coalition are over and with growth on track, looks like investors are positive on India. The recent IPO has also attracted institutional investors to India and we have seen large inflows coming into the economy. The only concern was the interest rate which has been modest with no rise. With companies reporting solid growth and profits calls for more capacity utilization leading to stronger growth. We expect oil worries to fade soon which would call for an INR appreciation in near term to 45 per dollar soon but with no direction coming from the US dollar, we see INR to remain within 45.25-45.75 range for few trading sessions.

Domestic Currency:

Nepali Rupee was seen trading stronger during the month as INR appreciated against the US Dollar. Nepali Rupee appreciated by 50 paisa during the last week of October. The USD/NPR which started trading at 74.80 for the month appreciated against the US dollar and traded at 73.80 during the month end thus adding to an appreciation of 1 rupee during the month. The movement in Nepali rupee will be guided by the volatility in USD/INR trading levels.

Local Market:

T-Bills and Money Market:

91 days Treasury bills which started at 2.7224% pa in the beginning of October 2004 was trading at a slightly lower level at 2.3096% on the third week. Due to dearth of liquidity, T-Bill issue on the fourth week of October was not bid at all. In line with our earlier projection of last month, rupee rate moved sharply up due to heavy T-Bill issue from NRB and festive withdrawal for Dashain. However, the market was surprised as NRB capped off its longer term issues at 4.31 % on one hand and at the same time it raised the SLF rate by another 100 basis points i.e. the new SLF rate was fixed as 91 days T-Bill average rate plus 200 basis points. As a result call money rate for rupee surged to the level above 4 % for the last two weeks of October.

Inter-bank call money rate traded between 2.50% pa - 4.15 % pa during the month of October. As the SLF rate continues above 3 % pa, Inter-bank call money rate is expected to hover around this level. However, the call money rates will highly be influenced for the next month by the amount of deposit that enters the banking system which virtually was withdrawn during Dashain and upcoming Tihar festival.

Our Central Bank for the first time in the history issued NPR 2.0 billion worth REPO auction and the same traded between 91 days T/Bill rate and the SLF rate.

Disclaimer:

This publication is for information only and is not to be construed as an offer to buy or sell investments. Nabil Bank Limited, whilst considering the contents to be reliable, takes no responsibility for any individual investment decisions based thereon.

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