Prescott's work in lay terms

“You don’t want to pigeonhole Ed Prescott,” said Robert E. Lucas Jr., the 1995 Nobel Laureate in economics, describing the wide scope and impact of Edward C. Prescott’s work. “He has worked on so many problems — problems not closely connected.” The Nobel Committee of the Swedish Academy of Sciences chose to recognize two bodies of Prescott’s work, developed in collaboration with Finn Kydland, when it awarded the Nobel Prize. The list of significant work is much longer, however. Below, a summary of Prescott’s major ideas, beginning with the Nobel-cited work:

Time Consistency of Economic Policy

Often governments will set economic policy, only to give in to expediency when the right (or wrong) conditions or politics are present. Individuals and firms, like the children of indulgent parents, begin to anticipate that the rules will be loosened. As a result, economic policy looses its efficacy as the actors in the economy make decisions based not on policy, but on the expectation that the policy will be gutted when convenient. This research has affected the debate over economic policy formation and implementation in many countries, and has led to the development of independence in central banks.

Driving Forces Behind Business Cycles

After World War II, economists explained fluctuations in the business cycle as a function of shocks to the demand side of the economy. That model shed little light on the reasons for the turbulence of the ’70s, however, as the economy moved in seemingly contradictory directions. Prescott and Kydland showed that shocks to the supply side, such as oil price shocks and technological innovation, may have far-reaching effects. A key aspect of this work was the view that business cycles represent efficient responses of the economy to shocks that impinge on it.

Hours of Work and Taxes

Americans now work 50 percent more than the Germans, French and Italians, yet 30 years ago Europeans worked more. Prescott probed for the answer to this phenomenon by examining the link between taxes on labor income and hours worked. He showed that tax rates account for the difference. High taxes in the European nations studied are a disincentive to work, as people who may have wanted to work more choose not to because of the tax bite.

Impact of Barriers to Technological Development

In their book “Barriers to Riches,” Prescott and his co-author, Stephen Parente, looked at the relative wealth of nations and asked why some countries are richer than others. They found that the gap in wealth can be explained by barriers erected in those countries to the adoption of technological advances. Often, they wrote, these barriers protect industry insiders. If these barriers were to be lifted, productivity in those countries would rise Ð increasing the wealth and well-being of the citizens.

The Equity Premium Puzzle

All things being equal, investors do not like risk. This implies that an investor will hold an asset with more risk only if it also offers a higher expected return.
This observation can potentially explain why risky assets like stocks (i.e., equity) have historically earned much higher returns than a relatively risk-free asset like the three-month U.S. Treasury Bill. However, more than 20 years ago, Prescott and his co-author, Raj Mehra, showed that the difference in the average returns (the equity premium) is much larger than what theory predicts, giving rise to the now-famous “equity premium puzzle.”
More recently, working with co-author Ellen McGrattan, Prescott showed the importance of accounting for the tax and regulatory treatment of different investments. If returns are correctly measured, then the equity premium is in line with what theory predicts, and the apparent puzzle is explained. — Liz Farquhar

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