Earlier today, the Royal Swedish Academy of Sciences awarded the Nobel Prize in Economics to Americans Thomas J. Sargent and Christopher A. Sims "for their empirical research on cause and effect in the macroeconomy." Sargent, a professor at NYU, and Sims, a professor at Princeton, had looked at how government policies impact the economy; a former Federal Reserve economist told the Wall Street Journal, "They've totally changed the way people do macroeconomics. There's a pre-Sargent/Sims and a post-Sargent/Sims. It's that significant."

For economic policy nerds, the Times notes that Sims' work is "primarily... [around] temporary policy changes, such as a surprise in government finances or a change in interest rates. For example, his methods have been used to determine whether a central bank’s decision to raise rates affected inflation, or whether bank officials raised the interest rate precisely because they expected that inflation change later on," while Sargent has "focused on longer-run structural changes in the economy, such as setting a new inflation target. His research has analyzed historical data to better understand how these types of policy changes affect the economy over time. He has also conducted experiments in a sort of laboratory setting to examine how new policies might affect the economy."

When asked if there was a way to use their research for the current economic crisis, Sims said, "There’s no simple way to apply it. It requires a lot of slow work looking at data -- the methods I use and that Tom have developed are central to finding our way out of this mess."

From the Nobel press release:

How are GDP and inflation affected by a temporary increase in the interest rate or a tax cut? What happens if a central bank makes a permanent change in its inflation target or a government modifies its objective for budgetary balance? This year's Laureates in economic sciences have developed methods for answering these and many of other questions regarding the causal relationship between economic policy and different macroeconomic variables such as GDP, inflation, employment and investments.

These occurrences are usually two-way relationships - policy affects the economy, but the economy also affects policy. Expectations regarding the future are primary aspects of this interplay. The expectations of the private sector regarding future economic activity and policy influence decisions about wages, saving and investments. Concurrently, economic-policy decisions are influenced by expectations about developments in the private sector. The Laureates' methods can be applied to identify these causal relationships and explain the role of expectations. This makes it possible to ascertain the effects of unexpected policy measures as well as systematic policy shifts.

Thomas Sargent has shown how structural macroeconometrics can be used to analyze permanent changes in economic policy. This method can be applied to study macroeconomic relationships when households and firms adjust their expectations concurrently with economic developments. Sargent has examined, for instance, the post-World War II era, when many countries initially tended to implement a high-inflation policy, but eventually introduced systematic changes in economic policy and reverted to a lower inflation rate.

Christopher Sims has developed a method based on so-called vector autoregression to analyze how the economy is affected by temporary changes in economic policy and other factors. Sims and other researchers have applied this method to examine, for instance, the effects of an increase in the interest rate set by a central bank. It usually takes one or two years for the inflation rate to decrease, whereas economic growth declines gradually already in the short run and does not revert to its normal development until after a couple of years.

Although Sargent and Sims carried out their research independently, their contributions are complementary in several ways. The laureates' seminal work during the 1970s and 1980s has been adopted by both researchers and policymakers throughout the world. Today, the methods developed by Sargent and Sims are essential tools in macroeconomic analysis.

The pair will share the $1.48 million prize.