277
A government may try to deter the
building of homes in a flood-prone area
by not subsidizing flood insurance. But
if it has bailed people out after a flood
in the past, they will not be deterred.
See also: Economic man 52–53 ■ The Keynesian multiplier 164–65 ■ Monetarist policy 196–201 ■ Inflation and
unemployment 202–03 ■ Rational expectations 244–47
CONTEMPORARY ECONOMICS
new model predicted that if people
collect information and are rational,
they can—and will—anticipate
government interventions. They
then adapt their actions to the
government policy they expect, and
that policy is in turn rendered less
potent. Discretionary policy can
only work when individuals are
taken by surprise, and it is hard
to surprise rational individuals.
To see how this works, imagine a
lenient teacher who is trying to
make a lazy pupil do his homework.
The teacher tells the student that if
he doesn’t hand his homework in,
he will be punished. But the pupil
knows that the teacher is lenient
and does not like to punish. The
pupil anticipates that if he doesn’t
hand in the work, he won’t be
punished. Knowing this, he does
not do the homework. The teacher’s
aim of getting the pupil to hand in
his homework is undermined by
the pupil’s rational behavior.
Kydland and Prescott said
that government promises of low
inflation face the same problem.
The government does not like high
unemployment. So it will boost the
economy to keep unemployment
low, but this will push up inflation.
Like the teacher who threatens a
punishment he will not inflict, the
government has conflicting aims.
Individuals know this and so do not
believe the government’s promise of
low inflation. This undoes the aim of
increasing demand to lead to higher
employment, because people knowthat higher wages will be offset
by higher prices. Accounting for
rational expectations, the effect of
the boost is simply higher inflation.An uncompromising rule
The solution for our teacher would
be a compulsory school rule for
punishing late homework so he
would have to comply. In a similar
way Kydland and Prescott
proposed that instead of having a
free reign to set economic policy,
governments should commit to
following clear rules. A more radical
solution of the teacher’s dilemma
would be to delegate punishment-
giving to a strict principal. In
macroeconomic policy this kind of
role can be taken by independent
central banks, which place less
weight on employment and more
weight on low inflation than the
government does. Their control
of monetary policy allows the
government to credibly commit
to low inflation. The period of low
inflation that arose in the 2000s
is often attributed to the rise of
independent central banks. ■Finn Kydland Born on a farm in Gjesdal, Norway,
in 1943, Finn Kydland was the
oldest of six children. After high
school he taught in a junior school
for several years, where a fellow
teacher suggested he study
accountancy, which awakened
his interest in business. He
started an economics degree at
the Norwegian School of Economic
and Business Administration
(NHH) in 1965. Kydland intended
to become a business manager,
but after graduation he became an
assistant to economics professor
Sten Thore, who moved to
Carnegie Mellon University,taking Kydland with him.
Returning to NHH in 1973,
Kydland published his key paper
with Edward Prescott. In 1976,
Kydland returned to the US,
where he has taught ever since.
In 2004, he was awarded the
Nobel Prize for Economics.Key works1977 Rules Rather than
Discretion (with E. Prescott)
1982 Time to Build and
Aggregate Fluctuations
2002 Argentina’s Lost Decade
(with Carlos E. J. M. Zarazaga)