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Congratulations to Thomas J. Sargent, coauthor (with Lars Ljungqvist) of Recursive Macroeconomic Theory and one of two Americans awarded The 2011 Sveriges Riksbank Prize in Economic Sciences Nobel Prize on October 10, 2011 “for their empirical research on cause and effect in the macroeconomy.”[1] Currently a macroeconomics professor at the Stern School of Business at New York University, Sargent has made a name for himself in the economic world with his theory of rational expectations and dynamic macroeconomics.
To celebrate Sargent's award, here's an excerpt from Recursive Macroeconomic Theory that describes the methodology of dynamic macroeconomics:
Dynamic programming is now recognized as a powerful method for studying private agents’ decisions and also decisions of a government that wants to design an optimal policy in the face of constraints imposed on it by private agents’ best responses to that government policy. But it has taken a long time for the power of dynamic programming to be realized for government policy design problems.
Dynamic programming has been applied since the late 1950s to design government decision rules to control an economy whose transition laws included rules that described the decisions of private agents. In 1976 Robert E. Lucas, Jr., published his now famous critique of dynamic-programming-based econometric policy evaluation procedures. The heart of Lucas’s critique was the implication for government policy evaluation of a basic property that pertains to any optimal decision rule for private agents with a form that attains a Bellman equation like…Therefore, Lucas asserted that econometric policy evaluation procedures that assumed that private agents’ decision rules are fixed in the face of alterations in government policy are flawed. Most econometric policy evaluation procedures at the time were vulnerable to Lucas’ criticism. To construct valid policy evaluation procedures, Lucas advocated building new models that would attribute rational expectations to decision makers. Lucas’s discussant Robert Gordon implied that after that ambitious task had been accomplished, we could then use dynamic programming to compute optimal policies, i.e., to solve Ramsey problems.
But Edward C. Prescott’s 1977 paper entitled “Should Control Theory Be Used for Economic Stabilization?” asserted that Gordon was too optimistic. Prescott claimed that in his 1977 JPE paper with Kydland he had proved that it was “logically impossible” to use dynamic programming to find optimal government policies in settings where private traders face genuinely dynamic problems…
Much of the subsequent history of macroeconomics belies Prescott’s claim of “logical impossibility.” More and more problems that smart people like Prescott in 1977 thought could not be attacked with dynamic programming can now be solved with dynamic programming. Prescott didn’t put it this way, but now we would: in 1977 we lacked a way to handle history dependence within a dynamic programming framework. Finding a recursive way to handle history dependence is a major achievement of the past 25 years…
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