T H E P R I Z E I N E C O N O M I C S C I E N C E S 2 0 11

INFORMATION FOR THE PUBLIC

The art of distinguishing between cause and effect

in the macroeconomy
How are GDP and inflation affected by a temporary increase in the interest rate or a tax cut? What
happens if a central bank makes a permanent change in its inflation target or a government modifies
its objective for budgetary balance? This year’s Laureates in economic sciences, Thomas J. Sargent
and Christopher A. Sims, have developed methods for answering these and many other questions
regarding the causal relationship between economic policy and different macroeconomic variables
such as GDP, inflation, employment and investments.

The economy is constantly affected by unanticipated events. The price of oil rises unexpectedly, the cen-
tral bank sets an interest rate unforeseen by borrowers and lenders, or household consumption suddenly
declines. Such unexpected occurrences are usually called shocks. The economy is also affected by more long-
run changes, such as a shift in monetary policy towards stricter disinflationary measures or fiscal policy
with more stringent budget rules. One of the main tasks of macroeconomic research is to comprehend
how both shocks and systematic policy shifts affect macroeconomic variables in the short and long run.
Sargent’s and Sims’s awarded research contributions have been indispensable to this work. Sargent has pri-
marily helped us understand the effects of systematic policy shifts, while Sims has focused on how shocks
spread throughout the economy.

Two-way relationships and prevailing expectations

One difficulty in attempting to understand how the economy works is that the relationships are often
reciprocal. Is it policy that influences economic development or is there a reverse causal relationship? One
reason for this ambiguity is that both private and public agents actively look ahead. The expectations of the
private sector regarding future policy affect today’s decisions about wages, prices and investments, while
economic-policy decisions are guided by expectations about developments in the private sector.

Investors base their decisions on expectations about future Central banks set the interest rate based on expectations
economic policy. about private sector developments.
 A clear-cut example of a two-way relationship is the economic development in the early 1980s, when many
countries shifted their policy in order to combat inflation. This change was primarily a reaction to eco-
nomic events during the 1970s, when the inflation rate increased due to higher oil prices and lower produc-
tivity growth. Consequently, it is difficult to determine whether the subsequent changes in the economy
depended on the policy shift or on underlying factors beyond the control of monetary and fiscal policy
which, in turn, gave rise to a different policy. One way of studying the effects of economic policy would be
to carry out controlled experiments. In practice, however, varying policies cannot be randomly assigned
to different countries. Macroeconomic research is therefore obliged to use historical data. The laureates’
foremost contribution has been to show that causal macroeconomic relationships can indeed be analyzed
using historical data, even in cases with two-way relationships.

There are good reasons to believe that unexpected shifts in economic policy may have other effects than
anticipated changes. It is not trivial, however, to distinguish between the outcomes of expected and unex-
pected policy. A change in the interest rate or tax rate is not the same as a shock, in the sense that at least
part of the change might be expected. This is a longstanding insight in the context of the stock market.
A firm which reports improved earnings and higher forecasted profits might still encounter a drop in its
share price, simply because the market expected an even stronger report. Moreover, the effects of an unan-
ticipated policy shift might depend on whether it was implemented independently of other shocks in the
economy or was a reaction to them.

Sargent’s awarded research concerns methods that utilize historical data to understand how systematic
changes in economic policy affect the economy over time. Sims’s awarded research instead focuses on
distinguishing between unexpected changes in variables, such as the price of oil or the interest rate, and
expected changes, in order to trace their effects on important macroeconomic variables. The questions
which the laureates have dealt with are obviously interrelated. Although Sargent and Sims have carried out
their research independently, their contributions are complementary in many ways.

Sargent: systematic effects of economic policy

What happens in the macroeconomy when monetary policy systematically follows a Taylor rule, i.e., when
the interest rate responds to changes in inflation and the business cycle in a pre-determined pattern? Or
what happens if a central bank is instead given a mandate to maintain inflation close to two percent?
Sargent’s analysis deals with the effects of such systematic policy rules and the consequences of changes in
the rules for policy. Expectations are an integral part of this analytical approach.

Is it possible to determine whether changes in the economy depend on shifts in economic policy? Could
such changes instead depend on fluctuations in the overall economy that prompt decision-makers to adopt
a different policy? Sargent has examined these issues using a three-step method.

His first step involves developing a structural macroeconomic model, i.e., an accurate mathematical description
of the economy. A number of parameters, which determine the relationships among different variables,
are introduced into the model. For instance, if we know that consumers’ aggregate demand for goods and
services is affected by the expected real interest rate, this relationship should be incorporated in the model.
The parameters governing such basic relations should not be affected by the changes in economic policy.
This includes preference parameters, which describe how individuals choose between saving and consump-
tion depending on interest rates and income.

The second step consists of solving the mathematical model. Sargent’s method focuses on expectations as
to how macroeconomic variables will change. For example, are expectations about inflation in the future

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THE PRIZE IN ECONOMIC SCIENCE S 2011  THE ROYAL SWEDISH ACADEMY OF SCIENCES  HTTP //KVA.SE
affected by changes in economic policy? A reasonable prerequisite for solving the model is that individuals’
inflation expectations in the model correspond to the forecasted inflation generated by the model itself.
Imposing such a requirement is easier said than done, however, and the second step in Sargent’s analysis
demonstrates how a solution may be found.

The third and last step is entirely statistical. Historical data are used to estimate the fundamental parameters
that do not change after a policy shift. To simplify, this implies that parameter values are chosen so that the
model will describe historical events as well as possible. In this way, numerical values are obtained for the
parameters which describe the economic structure. The complete model can than be used as a “laboratory”
to study the effects of different hypothetical experiments, such as a shift in monetary policy.

In a series of articles written during the 1970s, Sargent showed how structural macroeconomic models
could be constructed, solved and estimated. His approach has turned out to be particularly useful in the
analysis of economic policy, but is also used in other areas of macroeconometric and economic research.

Some of Sargent’s contributions were solely methodological, although he has also applied the new methods
in highly influential empirical research. For instance, he has analyzed historical episodes of hyperinflation
in different European countries. He has also examined the above-mentioned course of events in the 1970s
when many economies initially adopted a high-inflation policy and then reverted to a lower rate of infla-
tion. Sargent showed that the way expectations are formed by the general public as well as central banks’
understanding of the inflation process were based on gradual learning. This could explain why the decline
in inflation took such a long time.

Sims: identification and analysis of macroeconomic shocks

Sims shared Sargent’s criticism of the large macroeconometric models which were earlier used by research-
ers, central banks and ministries of finance. In his article “Macroeconomics and Reality” (1980), Sims
introduced a new way of analyzing macroeconomic data. He also concurred with Sargent in emphasizing
the importance of expectations. Sims proposed a new method of identifying and interpreting economic
shocks in historical data and of analyzing how such shocks are gradually transmitted to different macroeco-
nomic variables. His approach has had an enormous impact on research. It has also been used extensively as
a basis for decision-making in economic policy. Sims’s methodology may also be described in three steps.

In the first step, the analyst makes a forecast for macroeconomic variables using a vector-autoregression model
(a VAR model). This is a relatively simple model for statistical time series, where previously observed values
of the variables of interest are used to achieve the best possible forecast. The difference between forecast and
outcome – the forecasting error – for a specific variable may be regarded as a type of shock, but Sims showed
that such forecasting errors do not have an unambiguous economic interpretation. For instance, either an
unexpected change in the interest rate could be a reaction to other simultaneous shocks to, say, unemploy-
ment or inflation, or the interest-rate change might have taken place independently of other shocks. This
kind of independent change is called a fundamental shock.

The second step involves extracting the fundamental shocks to which the economy has been exposed. This is
a prerequisite for studying the effects of, for example, an independent interest-rate change on the economy.
Indeed, one of Sims’s major contributions was to clarify how identification of fundamental shocks can be
carried out on the basis of a comprehensive understanding of how the economy works. Sims and subse-
quent researchers have developed different methods of identifying fundamental shocks in VAR models.

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THE PRIZE IN ECONOMIC SCIENCE S 2011  THE ROYAL SWEDISH ACADEMY OF SCIENCES  HTTP //KVA.SE 3(5)
 Once the fundamental shocks are identified based on historical data, the third step in Sims’s method is an
impulse-response analysis. This illustrates the impact over time of the fundamental shocks to the macroeco-
nomic variables.

The figures on the left shows how an

DEVIATION FROM
STARTING POINT, %
GDP impulse in the form of an increase in
0,2
the interest rate set by the central bank
leads to responses in macroeconomic
0,0
variables with different time profiles.
-0,2
The graphs are based on a VAR analy-
sis of U.S. postwar data (Christiano,
-0,4 Eichenbaum and Evans, 1999), where
QUARTER AFTER
the shocks have been indentified using
-0,6 INTEREST RATE a method proposed by Sims.
0 2 4 6 8 10 12 14 16 INCREASE

DEVIATION FROM
STARTING POINT, % Price level The example shows the responses of
0,2 two variables in the VAR model, GDP
and the price level. GDP falls continu-
0,0 ously for several quarters following the
interest rate increase and does not turn
-0,2 upwards until after six quarters. The
price level, on the other hand, is hardly
-0,4
affected at all until after six quarters,
QUARTER AFTER when prices start to fall – the rate of
-0,6 INTEREST RATE
0 2 4 6 8 10 12 14 16 INCREASE inflation goes down.

Effects of an increase in the interest rate on GDP and

Impulse-response analysis has impro-
the prize level. The shaded areas show other statisti-
cally possible outcomes. ved our understanding of the dynamic
properties of the macroeconomy and
has thereby affected the conduct of
monetary policy. It is now common for central banks with an inflation target to adjust the interest rate
in order to reach its goal over a horizon of one to two years, i.e., the time lag indicated by the figure. The
graphs also illustrate that a contractionary monetary policy faces a trade-off between lower inflation after
one to two years and an immediate reduction in GDP. Analogous VAR analyses of fiscal policy have shown
how increased public spending may counteract a temporary dip in the business cycle. Today, VAR models
are indispensable tools for central banks and finance ministries in their analyses of the impact of various
shocks on the economy and of how the economy is affected by different policy measures.

Empirical macroeconomic research today

Sargent’s analysis of macroeconomic time series based on historical data opened up a rich field for macro-
economic research and has led to new insights about the workings of economic policy. Sims research, start-
ing somewhat later, has also had an extraordinary influence, both in macroeconomics and other fields of
research. Today, the directions of research that were inspired by Sargent’s and Sims’s contributions have
much in common. In modern research, the solution to models developed using Sargent’s methods are often
expressed in the form of a VAR system and evaluated by impulse-response analysis.

The empirical strategies proposed by Sargent and Sims are intercomparable. In order to study the impact
of systematic policy changes on the economy, Sargent’s method requires specific assumptions about the

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THE PRIZE IN ECONOMIC SCIENCE S 2011  THE ROYAL SWEDISH ACADEMY OF SCIENCES  HTTP //KVA.SE
structure of the economy – assumptions that may be questionable. The assumptions underlying a VAR

Illustrations: Johan Jarnestad

model, on the other hand, are more general and hold across a wide class of economic models. Researchers
have a choice of method depending on the application. With detailed knowledge about the structure of the
economy, Sargent’s method may be preferable, in particular since it allows a counterfactual analysis of sys-
tematic changes in economic policy. When knowledge of the field is less exact, Sims’s method may be safer.

Owing to the scientific contributions of Sargent and Sims, research in macroeconomics and analysis of eco-
nomic policy have advanced substantially. Their combined work constitutes a solid foundation for modern
macroeconomic analysis. It is hard to envisage today’s research without this foundation.

LINKS AND FURTHER READING

Additional information on this year’s Prizes, including a scientific background article in English, may be
found at the website of the Royal Swedish Academy of Sciences, http://kva.se, and at http://nobelprize.org.
The latter also includes web-TV versions of the press conferences at which the awards were announced.
Information on exhibitions and activities related to the Nobel Prizes and the Prize in Economic Sciences
may be found at www.nobelmuseet.se.
Interviews
Evans G.W. and Honkapohja S. (2005) An Interview with Thomas Sargent, Macroeconomic Dynamics, 9, 561–583.
https://files.nyu.edu/ts43/public/research/SargentinterviewMD.pdf
Hansen, L.P. (2004) An Interview with Christopher A. Sims, Macroeconomic Dynamics, 8, 273–294.
Rolnick, A.J. (2010) Interview with Thomas Sargent, The Region, Vol. 24, No 3.
www.minneapolisfed.org/publications_papers/pub_display.cfm?id=4526
Rolnick, A.J. (2007) Interview with Christopher Sims, The Region, Vol. 21, No 2.
www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3168
Lectures (video)
Sargent, T. J. (2010) Uncertainty and Ambiguity in American Fiscal and Monetary Policies, Old Theatre, London.
www.youtube.com/watch?v=ofhaWMF1r6Q
Sims, C. A. (2010) How Empirical Evidence Does or Does not Influence Economic Thinking and Theory: Calibra-
tion, Statistical Interference and Structural Change, The Institute for New Economic Thinking.
http://ineteconomics.org/video/conference-kings/empirical-evidence-christopher-sims
Review articles
Fernández-Villaverde, Jesús and Juan F. Rubio-Ramírez (2010) Structural vector autoregressions, The
New Palgrave Dictionary of Economics, 2nd Edition, Eds. S.N. Durlauf and L.E. Blume, Palgrave Macmillan.
Piazzesi, Monika (2008) Rational expectations models, estimation of, The New Palgrave Dictionary of Eco-
nomics, 2nd Edition, Eds. S.N. Durlauf and L.E. Blume, Palgrave Macmillan.
Sargent, T. J. (2008) Rational expectations, The New Palgrave Dictionary of Economics, 2nd Edition, Eds.
S.N. Durlauf and L.E. Blume, Palgrave Macmillan.
Zha, Tao (2008) Vector autoregressions, The New Palgrave Dictionary of Economics, 2nd Edition, Eds. S.N.
Durlauf and L.E. Blume, Palgrave Macmillan.

THE L AUREATES
THOMAS J. SARGENT CHRISTOPHER A. SIMS
U.S. citizen. Born 1943 in Pasadena, CA, USA. Ph.D. 1968 U.S. citizen. Born 1942 in Washington, DC, USA. Ph.D.
from Harvard University, Cambridge, MA, USA. William 1968 from Harvard University, Cambridge, MA, USA.
R. Berkley Professor of Economics and Business at New Harold H. Helm ’20 Professor of Economics and Banking
York University, New York, NY, USA. at Princeton University, Princeton, NJ, USA.

http://files.nyu.edu/ts43/public www.princeton.edu/~sims/

© The Royal Swedish Academy of Sciences

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