Finn Kydland and Edward Prescott's contribution to the theory of macroeconomic policy

Finn Kydland and Ed Prescott have transformed the field of macroeconomics with two path-breaking contributions. One is the idea of time inconsistency of optimal policy rules. The second is their analysis of business fluctuations. Both contributions have profoundly changed the way we think about macroeconomic problems, both in academic research and in practical policymaking. But while their analysis of business fluctuations is the result of a research effort that lasted more than two decades, the idea of time inconsistency of policy stems from a single paper, Kydland and Prescott (1977). After writing that paper, Kydland and Prescott have not returned to this topic except in a methodological paper on capital taxation; see Kydland and Prescott (1980). Yet, the idea was so important and powerful as to open up a whole new line of research in macroeconomics, that changed the way we study and implement economic policy. Rarely has a single paper had such a profound effect on economic research and the practice of economic policymaking. In this paper, I discuss the idea of time inconsistency, how it was formulated by Kydland and Prescott, and why its implications are so important. Section II sets the stage and places the contribution by Kydland and Prescott in the context of the theory of macroeconomic policy. Section III analyses earlier formulations of the notion of time inconsistency. Section IV summarises Kydland and Prescott’s contribution and its main implications. Section V briefly considers their impact on subsequent research and Section VI concludes