Blanchard, Galí and Woodford win Frontiers of Knowledge Award for Economics

The committee hails them as “central architects of the New Keynesian paradigm,” currently the most accepted framework for the analysis of macroeconomic policy. This paradigm, they added, “has been widely used to analyze the stabilizing effect of monetary and fiscal policy on the cyclical movements of real economic activity, unemployment, and inflation.”

This combination of academic research and influence on policy design has meant that the model they constructed “is used by central banks the world over in their monetary policy decision-making and taught throughout the academic world,” said committee member Antonio Ciccone, Professor of Macroeconomics and Financial Markets at the University of Mannheim, Germany.

“They put the pieces in place for a new model that seeks to avoid business cycle fluctuations and keep unemployment or inflation at relatively stable levels,” explained Fabrizio Zilibotti, Professor of International and Development Economics at Yale University and also a selection committee member. “The New Keynesian theory,” he continued, “emphasizes the role of expectations, which were essentially left out of traditional models. In this model, demand depends on expectations of the future course of the economy. In other words, it looks to the future to make decisions in the present. This is the opposite of the classical models, which decide measures in the present by looking at events in the past.”

The relationship between inflation, interest rates and growth

Blanchard’s founding role in New Keynesian economics can be traced to a joint 1987 paper with Nobuhiro Kiyotaki (Frontiers of Knowledge laureate in Economics in the 13th edition of the awards), where they studied the effects of monetary policy under monopolistic competition. What they found was that nominal rigidities acted as a major distorting factor: when consumers turn pessimistic and cut back on their spending, aggregate output falls. In the absence of nominal rigidities, what would happen is that interest rates would be adjusted so they keep on buying enough to stop the economy from entering recession.

“What we argued,” says Blanchard, “was that there was a price externality, in the sense that in an environment of imperfect competition, price setters had very little incentive to change their prices in response to demand. But the result of each price not changing was that the price level didn’t move, and this led the demand effect to fall on output rather than on prices.”

In 1997, Michael Woodford co-authored a paper with Julio Rotemberg in which they made an econometric estimation of a quantitative model in the New Keynesian framework, laying a number of key theoretical grounds for the development of the New Keynesian model of monetary policy.

Two years later, Jordi Galí partially extended and synthesized this theoretical framework. The Catalan researcher published an article with Mark Gertler (Frontiers of Knowledge laureate in Economics in the 13th edition of the awards) and Robert Clarida, in which they turned their attention to the Taylor Rule, a set of functions relating inflation, interest rates and another economic variable which could be GDP growth or aggregate demand. The result was a guideline for central banks to design the best monetary policy for a given period.

Unconventional monetary policies to fight the financial crisis

This analysis would find practical expression in the unconventional monetary policies that dominated the response to the financial crisis of the start of this century. In Galí’s words: “Woodford’s contributions are a key input to the design of the policies followed by leading central banks when interest rates reach zero, so have no more room to fall.”

The first time they were wielded was in 2002, after the dotcom bubble burst. The U.S. economy was struggling to pull clear of recession and deflation risk loomed large. The Federal Reserve had already cut rates as far as they thought possible and its governors believed they had used up all scope for monetary policy maneuver, until Michael Woodford convinced them otherwise. In summer 2003, he recalls today, “they decided to experiment, I think successfully” with the use of forward guidance, managing expectations on future policy rates. Specifically, they announced their intention to keep interest rates low for a considerable period until certain economic conditions were fulfilled.

“Before the 2000s,” says Woodford, “it was commonly accepted by central banks that they should make decisions about how to intervene in markets, but they didn’t need to talk to the public at all about what they were doing, and certainly not to give any hints in advance about what they might do in the future. The idea of forward guidance instead argues that in addition to directly intervening in markets, it’s very important what central banks say to people, not just while they’re doing it, but to give them an idea of what they expect to do further down the road, perhaps months or even years into the future.”

When the financial crisis erupted in 2008, these policies had already been tested in a real-world situation, enabling the Federal Reserve to react quickly, implementing both forward guidance and quantitative easing, buying up large quantities of government securities. At around the same time, Olivier Blanchard was taking up the post of economic counsellor with the International Monetary Fund. During his tenure there, he had multiple occasions to apply the models he had helped devise, seeking to give context to the current juncture and outline alternative strategies. Through these critical insights he was able to shape policies at a vital time and contribute centrally to modern economic analysis.