The work cited by the Nobel Committee was largely done when Sargent and Sims were on the economics faculty at the University of Minnesota. What is the significance of the work done here, and why did it happen here and not at Harvard or MIT or Stanford?
What would happen to unemployment, inflation and growth if the Federal Reserve Board decided to raise interest rates? What would happen if Congress passed the president's stimulus plan? What if Congress and the states passed a balanced-budget amendment to the Constitution? These are the kinds of questions macroeconomists attempt to answer.
For the last 40 years, macroeconomists have gradually developed a consensus approach to such questions. It starts with a basic idea that was largely absent from the Keynesian models developed in the 1950s and '60s. The premise is that much depends upon how people's expectations about the future are affected by policy.
It should be obvious that expectations about the future shape the decisions of people and businesses. Whether it's a good idea to build a manufacturing plant today depends on what demand for its product will be -- or on what wages for workers will be -- well into the future. Deciding whether to buy a car or a refrigerator requires me to ask whether I will have a job next year and in the years after that.
Starting in the late 1960s, a small, intrepid band of economists at the University of Minnesota, Carnegie-Mellon University and Chicago, far from the prestigious universities on the coasts and the hotbed of policymaking in Washington, launched a research program that has fundamentally altered the analysis of economic policy.
Sargent and Sims took somewhat different but complementary approaches towards analyzing the formation of expectations. Sargent is the main champion of what's called the "structural macroeconometric" approach. The basic idea is to start with a complete model of the macroeconomy, estimating how people make decisions and form expectations using historical data, and distinguishing those behaviors that change when policy changes from those that don't. With such a model at hand, one can then perform policy exercises.
This purist approach, while intellectually satisfying, suffers from the need to oversimplify reality.
Sims argued that any analysis of the effects of policy must start by distinguishing policies that follow the course people and companies expect from policies that represent "surprises." He showed how this distinction could be used to map out the effects of current policies.
Sargent's and Sims' work -- and that of the other founders of modern macroeconomics like Robert Lucas (then at Carnegie-Mellon and Chicago), Edward Prescott (then at Carnegie and Minnesota) and Neil Wallace (then at Minnesota) -- was often derided for being overly abstract and hopelessly out of touch with what economists then involved with day-to-day policymaking knew about how people really behave. In this field, as in so many others, it required a serene confidence in themselves for these economists to march to the beat of a different drummer. The payoff is that ideas which were once regarded as hopelessly academic are at the core of today's teaching, research and policymaking.
Other economists associated with Minnesota, like Leo Hurwicz and Edward Prescott, have also won the Nobel Prize in economics. We are committed to ensuring that our future will be even better than our past. We remain committed to the view that good research in economics must take the long view, focus on fundamentals and rise above the passions of day-to-day policy debates.
As part of that commitment, last year the university launched a new initiative, the Heller Hurwicz Economics Institute, whose mission is to support frontier economic research and communicate our findings to the public, academics and policymakers. The institute will be holding its inaugural policy forum on Nov. 16 and 17; there, attendees will learn that the future of Minnesota economics is as bright as its past. Peter Diamond, the 2010 Nobel Laureate in Economics, will give the keynote address. Details can be found at www.hhei.umn.edu
V.V. Chari is a professor of economics at the University of Minnesota.