Top 7 Economic Models Developed by F.E. Kydland and E.C. Prescott

The following points highlight the top seven economic models developed by F.E. Kydland and E.C. Prescott.

Economic Model # 1. New Classical Model:

To the “rational expectationists”, counter cyclical monetary and fiscal policies will not make the economy more or less stable than it would otherwise be; they believe that such policies will not make the economy more or less stable than it would otherwise be; they believe that such policies simply have no systematic effect on the economy’s real variables such as output and unemployment.

In opposition to both the monetarists and the rational expectationists, the Keynesians hold the view that has long been their gospel: counter-cyclical policy can make a positive contribution to the stability system. In the rational expectations framework, the availability of information and the ability of decision makers to acquire new information play central roles.

Advocates of the rational expectations framework argue that after repeated attempts by the government to stimulate the economy, people catch on to the policy and come to expect inflationary pressure. But in order to stop inflation the government must announce its intentions in advance and convince people that it will do what it says.

Economic Model # 2. Models of Optimizing Agents:

F.E. Kydland and E.C. Prescott have developed models of optimizing agents. The government, anticipating the reactions of the private sector to its policy can maximize its objective function. This solves the problem of designing an optimal policy for government, which incorporates the private sector’s reaction.

In order for this solution to be stable, however, the private sector must trust the government. Otherwise, the private sector could put themselves in bad situations and wait for the government to save them. An Adaptive Regression Model designed for its application to time-series data is associated mainly with the names of T.F. Cooley and E.C. Prescott.

Economic Model # 3. Business Cycle Models:

Business cycles generally occur as a result of shifts in aggregate demand. Given the wide swings in economic activity, economic forecasting is one of the most important tasks of economists. Kydland and Prescott build their equilibrium business cycle model upon the assumption of utility maximization. The technique combines “equilibrium business cycle modeling “with modern tools of public finance and contrasts sharply with the conventional techniques-such as econometric model simulation.

Some of the most important business-cycle models along with their proponents are given under:

i. Monetary theories attribute the business cycle to the expansion and contraction of money and credit

ii. Innovation theories attribute the cycle to the clustering of important inventions such as surrounding the railroad or the automobile.

iii. The multiplier-accelerator model proposes thereby generating regular, cyclical fluctuations in output.

iv. Real-business cycle proponent hold that productivity shocks spread through the economy and cause fluctuations.

v. Equilibrium-business-cycle theories claim that misperceptions about price and wage movements lead people to supply too much or too little labour, which leads to cycles of output and employment.

This list just hints at the variety of explanations of movements in output, unemployment and prices. An economics entered the age of statistics and computers, macro-economic forecasting has made great progress.

Economic Model # 4. Models of Unemployment:

Any attempt to explain unemployment, especially at the macro-economic level, must have a suitable theory of the labour market. The move to ‘supply-side economics’ at the very least turns attention to this neglected aspect. But it is important that both sides be constantly kept in mind.

A theory, which deals only with the demand side, cannot be a full explanation; but the same is true of a theory, which considers only the supply side. Unemployment, like inflation, is riddled with confusion and it seems everyone is suffering from these two economic diseases namely unemployment and inflation at the national and global levels.

Economic Model # 5. Classical, Keynesian, Monetarists and New Classical Models of Unemployment:

In the classical model, the only unemployment is the difference between ‘full employment’ and the working population. J.M. Keynes assumed that money wages were inflexible downwards and explained his concept of ‘Involuntary unemployment’ through the influence of aggregate demand.

In addition, the term ‘natural unemployment’ was introduced into the literature by Milton Friedman. Search theory is one explanation for the growing level of voluntary unemployment. It is apparent that Search Theories are a sub-group of the new classical economists. The reduction in the uncertainty is a means of increasing the efficiency of labour market.

Economic Model # 6. Search Models of Unemployment:

New classical economists assume that free markets are efficient and equilibrium will always be achieved. In order to reduce the level of unemployment, the labour market must be rid of the distortions- trade unions, social security benefits etc., which impede the free market from working.

It is therefore, quite consistent to hear monetarists argue for a curb on trade union power and a reduction in unemployment benefits. A rise in aggregate demand will simply lead to higher prices. Another different view has also emerged in the literature, namely the relationship between search time and unemployment wherein a rise in the level of aggregate demand will raise the equilibrium of employment of labour due to price effect, demand and supply forces. The money wage will accordingly rise and those seeking jobs perceive an improvement in job opportunities.

Search theorists argue that the bulk of the natural rate of unemployment can be explained by this uncertainty and the need to search. A reduction in the natural rate of unemployment, therefore, requires improvement in methods of search; namely, improved information about the job market. The uncertainty on the supply side-skill and sustainability alters the level of unemployment, while the uncertainty on the demand side-wage and working condition alters the level of vacancies.

Economic Model # 7. Rational Expectations and Economics Policy:

Finn Kydland and Edward C.Prescott investigated the implications of rational expectations for choosing among alternative fiscal policy rules in their paper “A competitive Theory of Fluctuations and the Feasibility and Desirability of Stabilization Policy”, Kydland and Prescott consider a model in which the neutrality and non-neutrality hypotheses both obtain and their analysis focuses on the effects of changes in technology and shifts in fiscal policies on aggregate employment.

In their model, these effects are persistent, but not permanent. Kydland and Prescott conclude that tax rates should not respond either to fluctuations in economic aggregates or to temporary changes in public expenditures. The tax rates should remain constant or nearby constant over the cycle with the budget being balanced on average. This does not minimize fluctuations but does minimize the deadweight burden of financing government expenditure.

The choice among fiscal and monetary instruments depends on issues on timing and of the mix of demands to be affected. The government’s limited ability to forecast the future course of the economy and the effects of different stabilization policies is to be still the main reason for limiting policy activism.