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A Scoop of Economics

by Greg Rosalsky

On Monday morning, the world’s econ nerds tuned in to an announcement from Sweden to learn who won this year’s Nobel Prize in economics. And we got a lesson involving… ice cream.

The winners were Robert Hall of Stanford University and Michael Woodford of Columbia University. The prize committee honored them "for microeconomic foundations of macroeconomic stabilisation."

To explain what the heck that means — as we will try to do in this newsletter — Timo Boppart, an economist at Stockholm University and member of the prize committee, stood up and walked around like he was giving a TED Talk. At one point, he brought up an image on the screen behind him: an ice cream menu.

The Royal Swedish Academy of Sciences

Boppart used the ice cream menu to serve up a sweet lesson in economics.

“How do firms actually set prices?” Boppart asked. “ This is illustrated here with this ice cream menu. Prices do not adjust [on] a continuous basis. Firms instead set the price of this ice cream for a whole season.”

Ice cream was a poetic example. Because prices, like ice cream, can get sticky. In fact, economists use the term “sticky prices” to describe how prices can stubbornly stay put even as economic conditions change.

That seemingly minor detail can have huge consequences for the entire economy. Sticky prices are a cornerstone of what’s known as “New Keynesian economics” — a framework that has helped reshape macroeconomic theory and how policymakers think about fighting recessions and controlling inflation.

This year’s prize honored work that helped lay the foundations for New Keynesian economics. In the process, Hall, Woodford, and other scholars helped breathe new life into the ideas of economics giant John Maynard Keynes, whose intellectual legacy, for a time, seemed in danger of melting away.

To understand why, we need to go back to the 1970s, when the economy experienced something that, for some, seemed to invalidate Keynesian economics.

Keynesianism Gets A Brain Freeze

John Maynard Keynes is basically the father of macroeconomics, the study of how the entire economy works, including what the government can do to fight recessions, boost employment, and control inflation.

Keynes’ breakthrough came in the depths of the Great Depression, when he published The General Theory of Employment, Interest, and Money. He articulated an idea that may seem obvious today but challenged the economic orthodoxy of his time: an economy can get stuck in a prolonged slump, and the free market won’t necessarily get everyone back to work on its own. Instead, Keynes wrote, we needed the government to help boost spending, put people back to work, and return the economy to health.

If you’ve ever taken an Econ 101 class, you’ve probably heard about the “invisible hand” of the free market. It’s the idea that people and businesses pursuing their own interests in competitive markets can help the economy reach its full potential without the government having to step in. Keynes basically argued we couldn’t count on the invisible hand to pull the economy out of a slump. We needed the visible hand of the government.

Keynes influenced an entire generation of economists and policymakers. Even Milton Friedman, a strong advocate for the free market, was quoted in 1965 as saying, “We are all Keynesians now.” (He later said the quote was taken out of context.)

In the 1970s, however, the dominant Keynesian models — and the policies they helped guide — ran into trouble. Inflation and unemployment rose together — a painful combination known as “stagflation.” The existing Keynesian models struggled to explain it.

“For a long time, the recipes of Keynes seemed to work, but they then failed during the oil crisis in the 1970s when high unemployment and high inflation took over simultaneously,” said John Hassler, the chair of the Nobel committee, when they announced the prize.

When the old-school models faltered, some economists wanted to reject Keynes wholesale. Economists like Robert Lucas and Edward Prescott — who each won Nobel prizes — challenged Keynesian economics and its confidence that government policy could effectively smooth out the economy’s ups and downs. Call it the revenge of the invisible hand.

A central criticism: the Keynesian models relied too heavily on patterns found in past economic data without adequately explaining the individual decisions behind them. Addressing that criticism meant giving models “microfoundations”: starting with the decisions of individual people and businesses to explain how the whole economy works. The economy is made of people, and people think ahead. They anticipate what policymakers will do, and those expectations shape how they spend, save, and invest. If policymakers change direction, people’s behavior might too — making old patterns an unreliable guide to whether a new policy will work.

One influential alternative to Keynesianism, developed by Prescott and other economists, became known as “real business cycle” theory. These models assumed that prices and wages were completely flexible, adjusting freely as economic conditions changed. If demand for workers fell, wages could fall too, making workers cheaper to hire and allowing the labor market to balance supply and demand. That left little room for a familiar feature of recessions: people who want to work but can’t find jobs.

Gregory Mankiw, now an economist at Harvard University, entered graduate school at MIT alongside Michael Woodford in 1980. They were learning macroeconomics just as economists were fighting over how to rebuild it.

“Lucas and Prescott were ascendant, but a lot of us were skeptical of their conclusions,” Mankiw tells Planet Money. “ And that's when people like Woodford and Hall sort of entered the stage. The sense was that the people who were rejecting the Keynesian model were throwing out the baby with the bath water. And so rather than throwing it out, they wanted to sort of fix the problems.”

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A Fresh Scoop of Keynes

Hall and Woodford helped rebuild macroeconomics around the decisions of individual people and businesses. Hall broke new ground in understanding how people’s expectations about the future shape their spending today. Woodford built on that work, developing a framework that combined forward-looking spending decisions with sticky prices.

To see why sticky prices matter, let’s return to the ice cream example. Say there’s a recession and demand for ice cream plummets. Shops might not quickly reduce ice cream prices to entice customers back. Maybe changing menus and signs costs time and money. Or maybe shops aren’t yet sure whether the drop in demand is temporary or here to stay. Instead, they keep prices frozen, sell fewer scoops, and ultimately may end up having to cut worker hours or lay people off. When prices don’t adjust, jobs and businesses take a hit.

The same story goes for wages, which we guess are a bigger factor in the economy than ice cream prices.

“ When economists talk about sticky prices, they're also including sticky wages — the price of labor,” Mankiw says. “Most people don’t get their wages adjusted every month.”

Across the economy, that stickiness or “price rigidity" can have big consequences. When spending drops, prices and wages don’t quickly and flexibly adjust to keep people buying and businesses hiring. Instead of prices falling to bring supply and demand together, in these models, price stickiness causes production and employment to fall. It helps explain why, during recessions, people who want to work can remain out of a job for long stretches.

“ Bringing in those price rigidities into the framework was absolutely key because this is the reason why the invisible hand cannot do its magic and there is room for policy intervention,” said Boppart at the Nobel prize announcement.

In other words, even when people and businesses think ahead and act in their own interests, sticky prices can keep the economy stuck in a slump. Call it Keynes’ comeback. In these models, governments and central banks still have a role to play in getting the economy back on track.

This was the promise of New Keynesian economics: take the criticisms of the old models seriously, rebuild models around individual decisions, and preserve Keynes’ central insight that the free market won’t always bounce back on its own.

“One thing that clearly differentiates Keynesian models from Real Business Cycle models was the flexibility or stickiness of prices,” Mankiw says. “Most economists today — not all — but I think most economists today buy into the sticky price assumption.”

These New Keynesian models became integral to how governments and central banks think about fighting recessions and controlling inflation.

Woodford’s work, for example, helped lay the theoretical groundwork for “forward guidance,” a strategy the Federal Reserve used during the Great Recession. The Fed slashed its benchmark interest rate to near zero, but the economy still needed stimulus. So under then-chair Ben Bernanke, the Fed signaled that it expected to keep interest rates low for an extended period. By shaping expectations about future rates, the Fed tried to help lower longer-term borrowing costs and encourage spending today.

Keynes’s ideas survived with new foundations. And Mankiw offers an update to Milton Friedman’s famous line: “We’re all New Keynesians now,” he says.

P.S. Throughout this piece, we’ve called this award the “Nobel Prize in economics.” But calling it that is surprisingly controversial. Technically, it has a much clunkier name. Economics wasn’t one of the prizes Alfred Nobel created. So how did it join the club? Ricky and I tell that story in the latest episode of The Indicator from Planet Money. Check it out when it’s released Tuesday.

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