How central banks learned to steer

An economy has good years and bad years. In bad years, many people lose their jobs. In very good years, prices can climb so fast that money buys less and less. Governments and central banks try to keep things steady, a bit like a driver who brakes before a sharp bend and speeds up on a straight road.

In the 1970s, the old instructions for driving the economy stopped working. Prices rose quickly while jobs disappeared at the same time. Robert E. Hall and Michael Woodford helped write new instructions. They started with ordinary people and shops, who all think about tomorrow when they decide what to do today.

Since John Maynard Keynes, almost a century ago, governments have tried to even out the business cycle. In a downturn they cut interest rates or raise the budget deficit to boost demand. In a boom they do the opposite. This is stabilisation policy, and its aim is to keep the economy away from both high unemployment and runaway inflation.

The traditional Keynesian models worked out the doses from statistical links between big aggregates. One is the Phillips curve: inflation tends to be low when unemployment is high, and the reverse. Another is that consumption follows current disposable income. During the oil crises of the 1970s these links broke. Inflation rose while unemployment rose too, stimulus arrived at the wrong time, and the West went through a decade of low growth and high inflation. Robert E. Lucas, Jr., the 1995 laureate, argued that the models needed microfoundations: they had to be built from how individual households and firms actually decide.

Michael Woodford built the full model. In his 2003 book Interest and Prices he set out a New Keynesian model with three equations. Households decide how much to spend by looking at expected income and the interest rate, using Hall's result. Firms set prices knowing they cannot change them often, so prices are sticky and every price decision looks ahead. A central bank steers the whole system with its interest rate. Woodford also introduced the output gap, the distance between actual output and the output the economy would produce if prices adjusted freely. Policy aims to push that gap toward zero.

Because households and firms look ahead, credibility and transparency become policy tools in their own right. A central bank that explains what it plans to do with rates shifts expectations, and with them spending and price setting, before it moves. According to the prize committee, this approach helped policymakers respond to the pandemic and the recent energy crises far better than in the 1970s, with shorter episodes of recession and high inflation.

The Lucas critique left macroeconomics with a demand that was easy to state and hard to meet. Policy models had to rest on behaviour that stays invariant when policy changes, which meant deriving aggregate relationships from optimising households and firms. They also had to stay simple enough for central banks to use. The 2026 prize rewards two contributions that made this possible: Hall's treatment of consumption under rational expectations, and Woodford's assembly of a tractable, microfounded model of monetary policy.

Woodford's Interest and Prices (2003) consolidated earlier work, including his microfounded sticky-price model with Julio Rotemberg, into what is now the textbook three-equation system. A dynamic IS curve is the log-linearised household Euler equation: the output gap depends on the expected future gap and on the real interest rate relative to the natural rate. A New Keynesian Phillips curve follows from staggered price setting of the Calvo type: inflation depends on expected future inflation and the output gap. An interest-rate rule closes the model. Following Wicksell, whose 1898 book his title translates, Woodford framed policy as setting an interest rate relative to a natural rate, rather than as controlling the money supply. He called the framework neo-Wicksellian.

Forward-looking pricing turns the expected path of policy rates into the main channel of transmission. Inflation today depends on expected future gaps, so a central bank acts through what it commits to as much as through the current rate. That is why credibility and clear communication became central to modern central banking. It also opened a new instrument: forward guidance, proposed by Woodford and others, let central banks stimulate demand by promising low future rates when current rates could not fall below zero, as in the United States from 2008 to 2015. The framework was a starting point, not a final word. Richer versions add wage rigidities, hand-to-mouth households in line with Hall's benchmark, and country detail, and Woodford's own recent work relaxes rational expectations. The three-equation core has nonetheless remained the common language of stabilisation policy.