Why does a home loan become more expensive? Why does the government cut taxes when growth slows? How can a central bank’s statement affect prices and jobs?
Robert E Hall of Stanford University and Michael Woodford of Columbia University, helped answer these questions.
The Royal Swedish Academy of Sciences awarded them the prize “for microeconomic foundations of macroeconomic stabilisation”. Their work showed how decisions made by families and businesses affect inflation, growth and jobs.
The prize recognises separate research. Hall studied how expected future income affects household spending. Woodford built on that finding in a model linking spending, business pricing, inflation and interest rates.
However, both economists studied expectations. Hall showed how they affect household spending, while Woodford explained their impact on the wider economy.
Governments have long tried to control recessions and inflation.
A central bank can cut interest rates when growth slows. Cheaper loans may encourage people to spend and companies to expand. The government can also cut taxes or spend more.
Rates can be raised when prices rise too quickly. Costlier loans reduce spending and may slow inflation.
These policies were influenced by British economist John Maynard Keynes, but the economic crisis of the 1970s exposed gaps in the models used at the time.
Several Western countries faced high inflation, unemployment and weak growth together. Some attempts to create jobs pushed prices up further.
The models studied broad links between inflation, employment and production. They did not properly explain the choices made by individual families and businesses.
Hall studied how people decide what to spend and what to save.
A person receives a one-time bonus of Rs 50,000. He knows his regular salary will not change and may save most of it.
Another person gets a permanent salary increase of Rs 10,000 a month. He may be more willing to buy a car or take a home loan.
Both have more money but may spend it differently because they have different expectations about their future income.
Hall argued in a 1978 study that changes in consumption should be difficult to predict if people use all available information while making spending decisions.
People usually change their spending after receiving new information, such as a promotion, job loss, illness or change in government policy. Such information cannot be predicted in advance.
Hall later studied individual households with economist Frederic Mishkin. They found that the consumption decisions of around 80 per cent of the households in their study were broadly in line with the theory.
The rest appeared to live closer to hand-to-mouth, with spending depending more on the money available at that moment.
A family with savings may save a tax rebate. One struggling to pay rent or buy food may spend it immediately. The difference matters when a government wants to increase demand.
Woodford studied how household spending, business prices, inflation and interest rates work together.
One part of his work dealt with “sticky prices”, which means companies do not change prices every time their costs move.
A restaurant may not print a new menu each time vegetable prices rise. A shop may delay a price increase because it fears losing customers. Wages may remain fixed under existing contracts.
Such delays can deepen a slowdown. People worried about their jobs may stop buying clothes, cars and electronic goods, but shops may not cut prices immediately. Ultimately, lower spending can lead to more job losses.
Woodford’s model explained how this cycle spreads through the economy.
People and businesses make decisions based on what they expect to happen next. A company expecting fuel and wage costs to rise may increase prices in advance. A family expecting interest rates to fall may wait before taking a home loan.
Central try to shape such decisions by indicating what they may do next. This is known as forward guidance.
A central bank may say rates will remain high until inflation falls. People may delay major purchases and companies may put expansion plans on hold.
Forward guidance became important after the 2008 financial crisis, when interest rates in several countries had already fallen close to zero. Central banks had little room to cut them further.
They told markets that rates would remain low for longer to keep borrowing costs down and support spending.
Models based on their work help policymakers examine what a rate change, tax cut or spending programme could do to inflation, growth and jobs. They also help identify why prices are rising.
Strong demand may be pushing up prices. A shortage of oil or other goods may be raising production costs. Each problem may require a different response.
An interest rate increase can control demand. It cannot produce more oil, food or computer chips. Higher rates can also make loans costlier and weaken growth.
These questions shaped policy after the 2008 financial crisis and during the Covid-19 pandemic. Governments spent money to protect jobs and businesses during lockdowns, while central banks kept borrowing costs low.
Inflation rose as economies reopened and supply chains remained disrupted. Central banks then raised interest rates to control prices.
The models help policymakers compare such risks but do not provide one correct answer.
The models have faced criticism for assuming that people behave more rationally than they do in real life.
Most people do not study inflation forecasts before buying groceries. Many cannot delay rent, school fees or medical expenses because interest rates are high. They may also not understand or trust a central bank’s message.
The models have treated households as more similar than they are. A rate increase can benefit someone with large savings and hurt a family paying a home loan.
Forward guidance also has limits. Some models suggested that a promise about interest rates several years later would have a large effect on spending today.
Research found that the actual effect could be much smaller. This became known as the “forward guidance puzzle”.
The 2008 financial crisis exposed another gap, with several models failing to give enough importance to banks, debt and risks inside the financial system.
Economists have since added different types of households, borrowing limits and financial risks to newer models. Woodford has studied what happens when people have limited information or do not plan far into the future.
Hall and Woodford changed how economists study booms, recessions and inflation.
Instead of treating the economy as a collection of broad numbers, their work began with the choices made by families and businesses. It also placed expectations at the centre of economic policy.
Models based on their work remain imperfect and continue to change. They cannot predict every crisis or tell governments exactly what to do.
They help explain policy choices, their risks and who gains or loses. The recognises this change in economic thinking.