The transformation of macroeconomic policy and research prize Lecture, December 8, 2004 by

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THE TRANSFORMATION OF MACROECONOMIC

POLICY AND RESEARCH

Prize Lecture, December 8, 2004

by

Edward C. Prescott*

Arizona State University, Tempe, and Federal Reserve Bank of Minneapolis,

Minnesota, USA.

1. INTRODUCTION

What I am going to describe for you is a revolution in macroeconomics, a

transformation in methodology that has reshaped how we conduct our science.

Prior to the transformation, macroeconomics was largely separate from the

rest of economics. Indeed, some considered the study of macroeconomics

fundamentally different and thought there was no hope of integrating 

macroeconomics with the rest of economics, that is, with neoclassical economics.

Others held the view that neoclassical foundations for the empirically deter-

mined macro relations would in time be developed. Neither view proved

correct.

Finn Kydland and I have been lucky to be a part of this revolution, and my

address will focus heavily on our role in advancing this transformation. Now,

all stories about transformation have three essential parts: the time prior to

the key change, the transformative era, and the new period that has been 

impacted by the change. And that is the story I am going to tell: how macro-

economic policy and research changed as the result of the transformation of

macroeconomics from constructing a system of equations of the national 

accounts to an investigation of dynamic stochastic economies.

Macroeconomics has progressed beyond the stage of searching for a theory

to the stage of deriving the implications of theory. In this way, macroeconomics

has become like the natural sciences. Unlike the natural sciences, though,

macroeconomics involves people making decisions based upon what they

think will happen, and what will happen depends upon what decisions they

make. This means that the concept of equilibrium must be dynamic, and – as

we shall see – this dynamism is at the core of modern macroeconomics.

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*Thanks to Dave Fettig, Tim Kehoe, Robert Lucas, Ellen McGrattan, Lee Ohanian, Richard

Rogerson, and Art Rolnick for their helpful comments and the National Science Foundation for

financial support (grant #0422539).

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Before proceeding, I want to emphasize that the methodology that transform-

ed macroeconomics is applicable to the study of virtually all fields of econom-

ics. In fact, the meaning of the word macroeconomics has changed to refer to

the tools being used rather than just to the study of business cycle fluctuations.

As a result of the transformation, these are exciting times in macroeconom-

ics. The methodology that Finn and I developed for the study of business cy-

cle fluctuations is being used to advance learning not only in the area 

of business cycles but also in virtually all areas of economics. By using this

methodology, researchers are able to apply theory and measurement to 

answer questions, define puzzles, and determine where better measurement

is needed before specific questions can be answered.

Over the last five years, I have addressed the following questions using this

methodology: What is the fundamental value of the stock market, and do fun-

damentals account for the large movements in the value of the stock market

relative to gross domestic product that have occurred over time? Why did

hours worked per adult fall by one-third in Western Europe, and not in

Canada and the United States, in the 1970–1995 period? Why were market

hours in the United States at the end of the 1990s 5 percent above what theory

predicts? Why did Japan lose a decade of growth beginning in 1992, a decade

when growth was at trend in the other advanced industrial countries?

Much of this recent research originates from my undergraduate teaching

that began in the late 1990s. Until then, I had never taught a course in which

macroeconomic questions were addressed using this methodology. The

undergraduate course I taught was Quantitative Analysis of the Macroeconomy.

I chose to teach this course because I felt there was a need to develop material

that could be used in teaching what macroeconomics has become at the

undergraduate level. I felt there was this need because Finn’s and my work on

the time consistency problem and developments in agency theory led me to

the conclusion that having good macroeconomic policy requires having an

educated citizenry that can evaluate macroeconomic policy. A second reason

why I thought there was this need is that by introducing talented undergrad-

uates to the excitement of modern macroeconomics, some would be influ-

enced to pursue careers in economic research and would make important 

advances to economic science.

In the course I introduced the real business cycle model economy, which is

the single sector growth model in which people decide how much of their 

income to consume and save and how much of their time endowment to 

allocate to the market. Motivated by Ragnar Frisch’s Nobel address (1970), 

I call this model the neoclassical growth model because it incorporates the 

willingness of people to substitute as well as their ability to substitute.

One decision that people must make is how to allocate their time endowment,

which is the most precious resource an individual has. Indeed, as my under-

graduates figure out, the present value of their time endowment is approxi-

mately 5 million current U.S. dollars, which makes them all multimillionaires.

Another crucial feature of any real business cycle model is that the model people

decide how much to consume and how much to invest or equivalently save.

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