The Editorial Board

Finn E. Kydland and Edward C. Prescott were awarded the 2004 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. Together, these two great economists have fundamentally altered the way we think about both optimal policy and business cycles. Kydland and Prescott met at the Graduate School of Industrial Administration (GSIA) at Carnegie Mellon University early in the 1970's. With the exception of a couple of years in the mid-1970's when they both were at the Norwegian School of Economics (NHH), it was here at GSIA that they did most of their pathbreaking work.

In the late 1960's there was a remarkable group of economists interested in dynamics and formation of expectations gathered at GSIA: John Muth, Robert Lucas, Morton Kamien, Nancy Schwartz, Richard Roll, and Thomas Sargent, among others.

An important finding was that the assumptions underlying the macroeconometric models of that time were inconsistent with rational expectations and dynamic economic theory. It was therefore imperative to develop models that answered questions regarding aggregate economic activity that were consistent with the theory of dynamic economic decision making under uncertainty. In order to achieve this it was necessary to ignore the artificial distinction between macroeconomics and microeconomics.

Solving the models that were necessary to answer these questions required mathematical and statistical methods with which economists at that time were not familiar. Within GSIA, economists, operations researchers, mathematical statisticians, and computer scientists were continuously and closely interacting. This cross-disciplinary culture of GSIA made it a unique place for developing the methods that were necessary for solving dynamic general equilibrium models.

In 1971, Edward C. Prescott, who had earned his Ph.D. from Carnegie Mellon in 1967, returned as an assistant professor. About the same time Finn E. Kydland (who had only applied to a single Ph.D. program!) came to GSIA as a doctoral student in economics. Illustrative of the cross-disciplinary atmosphere is that Kydland during his thesis work was primarily interested in operations research and programming.

Finn Kydland and Edward Prescott's long and fruitful collaboration resulted in at least two papers that forever changed the way we think about economics. Although they are topically different, these papers have commonalities that are not immediately obvious. They are also prime examples of research done at GSIA: they ask profound questions, they keep their models simple and take them seriously, they answer their questions within the framework of rational expectations dynamic general equilibrium, and they are methodologically innovative.

Kydland and Prescott's paper from 1977, “Rules Rather Than Discretion: The Inconsistency of Optimal Plans,” asked the question, What is the optimal policy within a dynamic framework where the economic structure can interact with the incentives of policymakers? After having worked out the logic of the model, they realized the implications of rational expectations in a dynamic general equilibrium setting. They understood how governments, by announcing policy, influence the expectations of the members of society, thus influencing their actions. The fundamental insight is, as the title indicates, that committing to policy rules might be better than having discretionary power at any point in time. If the government announces a best policy plan without committing to it, the members of society will understand the government's incentive to deviate from the policy and make their decisions accordingly, leading to suboptimal outcomes. With this paper, Kydland and Prescott laid the groundwork for the huge literature on time inconsistency of discretionary policy and have had enormous influence on how we analyze not only fiscal and monetary policy but any kind of dynamic interaction between individuals and institutions.

Kydland and Prescott's 1982 paper, “Time to Build and Aggregate Fluctuations,” asked the question, Might business cycles be the result of the efficient response of the economy to technology disturbances? The question Kydland and Prescott wanted to answer when they started writing this paper was whether growth theory with some extensions, in particular time to build, might provide a mechanism for the propagation of monetary disturbances. After they had derived the implications of the model without a monetary sector, they discovered that the business cycle fluctuations in the model economy were surprisingly close to observed aggregate fluctuations. One of the fundamental insights of the paper is that any plan, even though individuals have rational expectations about the future, will turn out to be ex post suboptimal. This paper quantified how the continuous process of adjusting and reoptimizing one's decisions will lead to fluctuations similar to observed business cycles movements.

Not only have these two papers shaped the way we think about economics, but they have had a major methodological impact on economic analysis. It is hard to pick up a recently published paper asking a question about the macro economy that is unrelated to the contributions made by Kydland and Prescott. Dynamic, stochastic general equilibrium models in the style of these papers are among the workhorses of modern economics, as are the methods Kydland and Prescott developed to solve these.

While both Finn E. Kydland and Edward C. Prescott usually are known as “macroeconomists,” they both resist the use of terminology that divides economics into subdisciplines or artificially distinguishes applied from theoretical economics. In their opinion—and in classical GSIA spirit—economic theory offers a set of organizing principles economists apply to understand the world. Perhaps their insistence on the unity of economic science explains why their seminal contributions have had such a profound impact on the entire field.