Study of Causal Relationships in Macroeconomics
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1 Study of Causal Relationships in Macroeconomics Contributions of Thomas Sargent and Christopher Sims, Nobel Laureates in Economics
2 1. Personal Background Thomas J. Sargent: PhD Harvard University 1968 Thesis Advisor: John Meyer Current Affiliation: NYU Christopher A. Sims: PhD Harvard University 1968 Thesis Advisor: Hendrik Houthakker Current Affiliation: Princeton University Class mates included: Robert Barro, Hayne Leland, Diedre (Don) McCloskey, Joseph Newhouse, Stephen Ross, Frank Sloan, Lance Taylor, Stephen Turnovsky 2
3 2. Nobel Citation Nobel Prize awarded: For their empirical research on cause and effect in the macroeconomy This year s Laureates in economic sciences have developed methods for answering questions regarding the causal relationship between economic policy and different macroeconomic variables such as GDP, inflation, employment and investments. 3
4 These occurrences are usually two-way relationships policy affects the economy, but the economy also affects policy. Expectations regarding the future are primary aspects of this interplay. The expectations of the private sector regarding future economic activity and policy influence decisions about wages, savings, and investments. Consequently, economicpolicy decisions are influenced by expectations about developments in the private sector. The laureates methods can be applied to identify these causal relationships and explain the role of expectations. This makes it possible to ascertain the effects of unexpected policy measures as well as systematic policy shifts. 4
5 Thomas Sargent has shown how structural macroeconometrics can be used to analyze permanent changes in economic policy. Christopher Sims has developed a method based on vector autoregression to analyze how the economy is affected by temporary changes in economic policy and other factors. Work is independent but complementary. --They have one joint paper at a Minneapolis Fed conference
6 3. Significance of Structural Macroeconomic Dynamics 12 of the Nobel prizes awarded in economics have been in the general area of macroeconomics (Assar Lindbeck). 5 include the general area of stabilization policy and contain this term or some close substitute in the citation. Pairing of Sargent with Sims is a little surprising. Sargent closely related to several previous Laureates Milton Friedman for his achievement in the fields of consumption analysis, monetary history and theory and for his demonstration of the complexity of stabilization policy. 6
7 Robert Lucas for having developed and applied the hypothesis of rational expectations, and hereby having transformed macroeconomic analysis and deepened our understanding of economic policy Finn Kydland and Edward Prescott for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind the business cycles Edmund Phelps, included the statement for his analysis of intertemporal tradeoffs in macroeconomic policy. [More detailed statement provided by Sveriges Riksbank refers to Phillips curve and role of expectations] Thomas Sargent and Christopher Sims for their empirical research on cause and effect in the macroeconomy. 7
8 While the contributions for which these prizes were awarded generally extend beyond stabilization policy, (particularly Friedman), they share several common themes. These include concepts such as: economic policy, Phillips curves, rational expectations, macroeconomic dynamics. Inter-relationships both in substance and personal: --Expectations-augmented Phillips curve simultaneously developed by Friedman and Phelps; cf Lucas supply function --Time consistency noted in Kydland-Prescott citation, also studied by Phelps (in 1968) --Rational expectations central to both Lucas and Sargent 8
9 Strong institutional connections: Chicago (Friedman, Lucas, Prescott, Sargent) Carnegie-Mellon (Lucas, Prescott, Sargent, Kydland) Minnesota (Sargent, Sims, Prescott) Also some brief connection with Pennsylvania (Phelps, Prescott, Sargent) Other institutional affiliations Sargent (Stanford, NYU) Sims (Harvard, Yale, Princeton) 9
10 Key objective of macroeconomic policy is economic stability. Interest in topic originated with Tinbergen (1952) [First Nobel Laureate 1969]. Employing a static linear framework proved: Under certainty the policymaker need use only as many policy instruments as there are independent target variables to achieve desired stabilization objectives. Economy inherently dynamic. Need dynamic framework. Also random shocks (stochastic) 10
11 A.W.H. (Bill) Phillips pioneer in the development of dynamic stabilization policy. Contributions were manifest in two seemingly different, but highly inter-related, areas and 1957 Economic Journal. Draw upon engineering background and are the first papers to apply feedback control to macroeconomic stabilization. 2. The Phillips curve (1958). Proposed as empirical relationship; but introduction into macroeconomic system has profound consequences for stabilization policy [Friedman, Lucas, Phelps, Sargent] Phillips contributions important background to subsequent research. Recognized by Sargent in paper with Hansen 11
12 4. Summary of Causal Relationships Fundamental problem in understanding economics is that relationships are often simultaneous. Does policy determine economic environment or reverse? Key reason for ambiguity is that both private and public agents look ahead and form forecasts (expectations). Expectations held by private sector about future policy affect current decisions; policy decisions are affected by expectations about future private sector behavior. Economics is hampered by inability to conduct controlled experiments; constrained to use historical data. Sargent and Sims contribution is how to analyze causal relationships using historical data. 12
13 Sargent focuses more on systematic effects of economic policy, where expectations play a key role. Question: Is it possible to determine whether changes in economy depend upon shifts in policy or do they depend on other factors (fluctuations)? 13
14 Sargent proposed three step procedure to addressing this. 1. Construct a structural macroeconomic model --Formal mathematical description of economy. This includes behavioral relationships, dependent upon socalled deep parameters, which are invariant with respect to policy (e.g. tastes, technology). In contrast to previous macro models these were based on microeconomic foundations. Earliest models based on perfectly flexible markets; later models introduce Keynesian notions of sticky wages and prices. 14
15 2. Solving the model --Key feature is evolution of expectations. Sargent assumes that expectations in the model correspond to the forecasts generated by the model; i.e. rational expectations (cf Lucas). --Both Lucas and Sargent s emphasis on rational expectations is a consequence of being at Carnegie- Mellon, where John Muth was a colleague. Muth developed the concept in the context of agricultural commodities markets. E. Mills had similar concept: implict expectations --Lucas and Sargent stressed its profound consequences for macroeconomic policy when introduced in a model with a Phillips curve. 15
16 3. Using historical data to estimate the fundamental parameters invariant with respect to policy More technical, econometric (techniques closer to those employed by Sims). Model can then be used to study effects of different hypothetical policy experiments. Need to take account of cross equation restrictions in estimation 16
17 5. Example Inflation: a E 1 a 1 a y, t E t t t y t t Output y (1 b ) E y 1 b y 1 b ( i E 1 ), t y t t y t y t t t y t Policy rule: i c c y ci 1, t t y t i t i t Coefficients: a,b,c are given; a,b, are micro parameters (tastes etc) c policy parameters Random shocks realized over time 17
18 Question: How does change in policy rule affect the evolution of the economy? Difficulty: Current outcomes depend upon expectations of the future Under rational expecations, expectations are formed consistent with this system With forward-looking behavior outcome at time t depends upon events at all future time periods, t+1, t+2, etc Sargent solution: look for forward-looking solution: x y,, i, and conjecture a solution of the form Let t t t t x Fx G t t 1 t Objective is to estimate basic parameters, a,b,c 18
19 With this notation structural system can be written as x Ax BE x Cx t t t t 1 t 1 t Because is unpredictable, Ex 1 and hence x Ax BFx Cx t t t t 1 t 19 Fx and hence t t t t t 1 t x A BF Cx A BF Conjectured solution is verified with 1 A BF 1 C F ; 1 1 A BF G These impose restrictions on parameters in estimation. Once parameters a,b are known, can assess effects of policy (c) on economy.
20 6. Overview Sargent s contributions extensive and diverse --Some methodological Previous introduction of expectations mechanistic; backward looking based on past lagged values; * e.g. X, 1,... tt f Xt 1, Xt 2 Xt n --involve systemmatic errors in forecasting. Equilibrium derived by solving dynamics backwards from some given initial condition. Tradition inherited from studying dynamics of physical objects. 20
21 Introduced forward looking expectations [see also Lucas] * X tt, 1 Et 1 Xt It 1 Prediction formed using information available, which includes structure of economy. Equilibrium derived by solving dynamics forward from some given future terminal condition that ensures intertemporal solvency. Simple illustration of contrast between backward-looking and forward-looking solutions, Sargent and Wallace (Econometrica 1973). This was main contribution of rational expectations. NOT policy neutrality, which is not a robust proposition (Sargent and Wallace) 21
22 Sargent s contribution to rational expectations modeling focused more on empirical implementation than did Lucas. Sargent in 1971 was one of the first to demonstrate the crucial role of expectations in econometric studies of the Phillips curve. --Applications to many different time periods, episodes, and countries. 22
23 Rational expectations a polar case. Sargent has done extensive work on least squares learning. Important in understanding dynamics of inflation. Bounded rationality 23
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