Christopher A Sims and Thomas J Sargent have jointly won the Nobel Prize in Economics this year for their contribution in "empirical research on cause and effect in the macroeconomy". It is needless to say that both of them have contributed significantly to the literature of economics for more than 40 years.
The Academy said in a statement: "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".
Professor Christopher Sims has made original contribution in econometrics and has written extensively on the issue of causality between two or more macroeconomic variables in relation to Professor CWJ Granger's work on money income causality.
In macroeconomics, it is important to understand the direction of causality between more than one variable particularly in order to take policy decisions. The general regression result tells us whether the variables are related or not. However, if for example, we are interested to know whether two related variables like growth in money supply and growth in GDP are caused by one another or, for that matter, there is bi-directional causality, we look at their past behaviours.
Generally it is tested by using appropriate number of lags, which is called vector autoregression. This is based on the philosophy that if historically the growth in GDP (in our example) precedes the growth in money supply, then GDP growth causes growth in money supply. However, Cambridge economists like Nicholas Kaldor and Joan Robinson criticised this philosophy by saying that this is a logical fallacy "post hoc ergo propter hoc".
Many economists argued that lag dependent tests of 'causality' are actually nothing but estimations for another kind of lagged dependent correlation. However the central question is to estimate empirically the direction of causality and Professor Sims has made enormous contribution in developing more and more sophisticated tools to improve the degree of precision in determination of the direction of causal relations in the literature of econometrics.
He was primarily interested in assessing the effect of various shocks such as surge in oil prices or sharp drop in household consumption to the economy etc.
Professor Thomas Sargent has made significant contribution in developing the modelling on the basis of assumption of rational expectations, which states that the economic agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. It has got wide applications in real business cycle models and empirical estimations.
However, these models are also not beyond criticism. The rational expectation hypothesis assumes that at any specific time, a market or the economy has only one equilibrium (which was determined ahead of time), so that people form their expectations around this unique equilibrium based on full employment or natural rate of employment assumption.
A further problem relates to the application of the rational expectations hypothesis to aggregate behaviour. It is well known that assumptions about individual behaviour do not carry over to aggregate behaviour. However, Prof. Sargent is considered to be one of the leaders of rational expectation revolution. Working with Neil Wallace, Sargent developed the saddle path stability characterisation of the rational expectations equilibrium. His work primarily focused more on systemic policy shifts rather than shocks. Many congratulations to both these economists.
(The writer is Economist at the National Institute of Public Finance & Policy. Views expressed are personal)
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