American economists Robert E. Hall and Michael Woodford won the Nobel Memorial Prize in economics Monday for their work on models that have helped governments and central banks manage economic shocks, such as energy crises and inflation.

The Royal Swedish Academy of Sciences announced the winners in Stockholm, noting that their work created the theoretical foundation to better understand how consumers decide whether to save or spend, insights that make it easier for policymakers worldwide to stabilize economies after fluctuations.

"The laureates' research has made it possible to manage major macroeconomic crises far more effectively than before," the Nobel committee wrote. "It has been hugely beneficial during the pandemic and the energy crises of recent years."

Hall is affiliated with Stanford University in California, and Woodford with Columbia University in New York.

Woodford spoke to the committee by phone from New York: "It's a tremendous honor. It's a surprise."

Duo overturned earlier assumptions

For decades, governments responded to economic shocks by following the Depression-era prescriptions of the British economist John Maynard Keynes: Intervene in the economy by lowering taxes and hiking government spending, thereby encouraging consumers and businesses to spend and invest and help restart growth.

"This is the Keynesian recipe and it worked well – until it didn't,'' said Timo Boppart of the Nobel economics committee.

Policymakers had thought economic management involved simple trade-offs – unemployment, for instance, would stay low at a time of high inflation and rise when inflation fell. But the " stagflation '' of the 1970s – when the world economy experienced simultaneous high inflation and high unemployment – proved the formula was simplistic.

Some economists argued that government attempts to intervene in the economy were doomed to fail. But Hall and Woodford, in separate contributions, set about improving the Keynesian model to take into account how consumers and businesses actually make decisions about whether to invest and spend.

"Economic outcomes are the result of millions of decisions made at the microlevel by households and businesses,'' the Nobel committee wrote. "Using models based upon this approach, rather than simply studying the economy from a macro perspective, like a bird's eye view," Hall and Woodford's research "generated a paradigm shift in the theory of stabilization policy.''

Consumer choices

Hall studied the way that consumer decisions about whether and how much to spend depend on what they expect their future income to be.

"If they are optimistic, they will consume more than if they are pessimistic,'' the committee wrote. But consumer expectations can change unexpectedly as new information about the economy comes in. And some households are so poor they can't borrow or tap savings in response to economic changes.

In a 1982 paper with the economist Fredric Mishkin, Hall found that around 80% of households made spending decisions based on their expectations for the future "while the rest lived hand to mouth,'' the committee wrote.

"The prize is for research that pushes our understanding of macroeconomics from the bottom up, from families and firms making decisions over time, while looking ahead," Ivan Werning, an economist at the Massachusetts Institute of Technology, said in an email.

How businesses make decisions

Woodford's research established that businesses make decisions about prices based on where they think interest rates will go in the future.

"If the business believes that its competitors' prices and its own costs will increase, it is best to set a higher price than it would with the opposite expectation," the Nobel committee wrote. "Businesses' decisions are thus also governed by their expectations.''

Therefore, central banks such as the U.S. Federal Reserve, which set short-term interest rates, should provide "clear and credible communication about how they reason and what they plan to do.'' Central banks have responded to this insight by working harder to explain what they are doing.

During the phone call broadcast at a news conference, Woodford said his work has stressed "the understanding of the people who are in the markets and making decisions about spending."

The economics prize is formally known as the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. The central bank established it in 1968 as a memorial to Nobel, the 19th-century Swedish businessman and chemist who invented dynamite and established the five Nobel Prizes.

Nobel purists stress that the economics prize is technically not a Nobel Prize, but it is always presented together with the others on Dec. 10, the anniversary of Nobel's death in 1896.

Nobel honors were announced last week in medicine, physics, chemistry, literature and peace.

Monday's award was the second Nobel win for a Stanford University professor this year. Dr. Karl Deisseroth shared the medicine prize with Peter Hegemann and Georg Nagel for their work that led to a tool that uses light to help unravel how the brain works.

The prize money this year is 12 million Swedish kronor (about $1.2 million), whether for an individual, a small group of laureates, or an organization.