Ice cream and sticky prices: Hall and Woodford win Nobel economics prize

Timo Boppart, an economist at Stockholm University and a member of the prize committee, walked through the price-setting idea by showing an ice cream menu on a screen. "How do firms actually set prices?" Boppart asked. "This is illustrated here with this ice cream menu. Prices do not adjust [on] a continuous basis. Firms instead set the price of this ice cream for a whole season." Economists call the phenomenon sticky prices. The seemingly small detail is a cornerstone of New Keynesian economics, a framework that has helped reshape macroeconomic theory and how policymakers think about fighting recessions and controlling inflation, according to NPR News.

This year's prize honored work that helped lay the foundations for New Keynesian economics. In doing so, Hall, Woodford and other scholars helped revive the ideas of John Maynard Keynes, whose intellectual legacy, for a time, seemed in danger of melting away.

Keynes is described as the father of macroeconomics, the study of how the entire economy works, including what government can do to fight recessions, boost employment and control inflation. His breakthrough came during the Great Depression with The General Theory of Employment, Interest, and Money. He argued that an economy can get stuck in a prolonged slump and that the free market will not necessarily get everyone back to work on its own. Government, he wrote, needed to help boost spending, put people back to work and return the economy to health. Where Economics 101 describes the "invisible hand" of competitive markets, Keynes argued that the visible hand of government was needed to pull the economy out of a slump. He influenced a generation of economists and policymakers. Milton Friedman, a strong advocate of free markets, was quoted in 1965 as saying, "We are all Keynesians now"; he later said the quote was taken out of context.

In the 1970s, the dominant Keynesian models and the policies they helped guide ran into trouble. Inflation and unemployment rose together, a painful combination known as stagflation. Existing Keynesian models struggled to explain it. "For a long time, the recipes of Keynes seemed to work, but they then failed during the oil crisis in the 1970s when high unemployment and high inflation took over simultaneously," said John Hassler, chair of the Nobel committee, when the prize was announced. When the old-school models faltered, some economists wanted to reject Keynes wholesale. Economists including Robert Lucas and Edward Prescott, who each won Nobel Prizes, challenged Keynesian economics and its confidence that government policy could effectively smooth the economy's ups and downs. NPR News described the push as a revenge of the invisible hand.

A central criticism was that Keynesian models relied too heavily on patterns found in past economic data without adequately explaining the individual decisions behind them. Addressing that criticism meant giving models "microfoundations": starting with the decisions of individual people and businesses to explain how the whole economy works. The economy is made of people, and people think ahead. They anticipate what policymakers will do, and those expectations shape how they spend, save and invest. If policymakers change direction, people's behavior might too, making old patterns an unreliable guide to whether a new policy will work.