It’s probably intuitive that macroeconomic forces must be derived, at least in part, from the actions of the billions of people and firms that contribute to the economy every day. But making precise links between the observed macroeconomy and the individual actions of specific agents is very difficult. Fortunately, for a huge array of practical purposes, economists are able to model and study macro-level trends like inflation without needing to know how they come about from the actions of underlying agents.

But when someone does try to explain macroeconomic phenomena by building up from microeconomics, economists often call it macroeconomics with a “microeconomic foundation”. This has been a practice for decades, but it’s still an active area of research and debate, and it’s partly what earned the 2026 Economics Nobel Prize winners their award.

Robert E. Hall and Michael Woodford won the 2026 Nobel Prize in Economics for “demonstrating how economic models could be reconstructed to revitalise stabilisation policy”, which is being used across central banking today, writes the Nobel Prize committee. Stabilization policy refers to the actions central banks take to help the economy recover from recessions and cool down during boom periods.

Let’s take a closer look at stabilization policy and its implications for how the economy is guided today.

How did the Nobel laureates' work influence stabilization policy?

Economic models of the economy have evolved continuously over time, mainly in response to two forces: economic events that discredited prior theories, and gaining access to better data and more computing power.

When Robert Hall and Michael Woodford began their Nobel-recognized work, the dominant policy theory of the mid-20th century (Keynesianism) had just suffered a major blow. The 1970s brought with it stagflation: a period of high inflation and high unemployment that confounded economists. In fact, at the time economists had developed and widely accepted the Philips Curve, which was thought to more or less prove that inflation and unemployment had an inverse relationship. Stagflation was thus a particularly ugly problem for economic theory, and economists’ inability to offer policy solutions for it made Keynesian models look inadequate.

But economists aren’t the type to easily give up! Discredited theories often indicate that there’s something new to be learned. And one of the key things missing from economic theory at the time was an understanding of how individual expectations of the future affected macroeconomic variables. This is the contribution of Robert E. Hall.

But first, consider that private consumption decisions are important for stabilization policy. That’s because when the central bank wants to encourage spending to boost the economy, there are two main units they’re attempting to influence: firms and individual consumers (or “households”). So, how consumers (and businesses) react to a central bank’s monetary policy will affect how useful that policy ends up being.

Hall’s major contributing idea was that rational, forward-looking consumers will adjust their consumption decisions today in response to what they perceive the future to hold, and thus economists could use consumption itself to measure consumer’s expectations about the future. In response to new information, optimistic consumers will increase consumption, since they expect the future to be prosperous. On the other hand, pessimistic consumers might reduce consumption in response to new (bad) information, because they expect they’ll need more savings for hard times ahead.

Thus, reasoned Hall, changes in consumer spending signaled changes in expectations about the economy. This was a breakthrough moment. Enter Michael Woodford, who used these insights about forward-looking economic expectations to derive the basis of the modern New Keynesian models.

This involves three key equations that determine the economy’s dynamics, some of which use the idea of to function.

A Crash Course in the New Keynesian model

The basic New Keynesian model is described by three main equations. These are, in no particular order:

• An equation that determines the interest rate as a function of economic output and inflation. This is often called a “Taylor rule”.
• An equation that determines economic output as a function of expected future employment, expected future inflation, and the nominal and real interest rates. This is often referred to as an “Investment-Savings”, or IS, equation.
• An equation that determines inflation as a function of economic output and expected future inflation.

These three core equations vary in complexity and are sometimes supplemented with additional equations, but they are the heart of the New Keynesian model still used by central banks today. Robert Hall’s contribution allowed Michael Woodford and other economists to build expectations into these models, even though Hall himself did not work on developing them directly.

Michael Woodford introduced a few new aspects of the New Keynesian paradigm that are familiar with policymakers today. This includes the term “output gap”, which measures if an economy is over- or under-performing (note that over-performance can be just as bad as underperformance!). It also includes the idea that changing interest rates, not just the money supply, can affect economic output — and thus should be a main tool of the central bank.

Recall that central banks have a “dual mandate” to protect the economy: keep both unemployment and inflation low. The three New Keynesian equations above describe how, by adjusting interest rates, central banks can influence both of those factors (employment is an implied function of economic output, but doesn’t appear directly in this basic model). And thus, it’s clear to see why this model has become so instrumental for modern economic policy. Now built upon microeconomic foundations, these NK models are still the workhorse models used by central banks for stabilization policy.

Why should stabilization policy aim to limit growth?

Eagle-eyed readers may have already noticed something odd about the Nobel Prize’s announcement. They state that Hall and Woodford won the award partly because their work enabled “well-timed fiscal and monetary policy measures [that] can reduce the economy’s peaks and troughs.” But…why do we want to reduce the economy’s peaks? Surely growth is a good thing!

The main reason is inflation. When the economy is performing well, everyone’s happy: business is booming and consumers are spending. But too much of this activity can make prices begin to rise rapidly, which can cause severe economic suffering down the road. This can occur due to economic “overperformance” (or, a positive output gap as defined by Woodford), where there is too much demand relative to existing supply or production, setting the stage for prices to spike.

Thus, central banks often choose to raise interest rates when the economy is performing well. Higher interest rates increase the returns on savings, which can cool off consumption, and make borrowing money to finance major investments harder, which in turn can slow down business activity. In good economic times, this may hurt slightly in the short term or hardly be noticed at all, but it can prevent later episodes of inflation that hurt much worse.

So, the next time you notice a central bank announcement, be sure to remember the work of these two Nobel Prize winners. Their insights and research have built a foundation that our modern world depends on quite a lot. Even our central banks stand on the shoulders of giants.

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References

The Prize in Economic Sciences 2026 – Scientific Background

The Prize in Economic Sciences 2026 – Popular Science Background 

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