13 October 1981

THIS YEAR’s PRIZE IN ECONOMICS AWARDED FOR RESEARCH ON THE
FINANCIAL SYSTEM AND ITS EFFECTS ON INFLATION AND EMPLOYMENT

The Royal Swedish Academy of Sciences has decided to award the 1981 Alfred Nobel Memorial Prize in Economic Sciences to

Professor James Tobin, Yale University, USA,

for his analysis of financial markets and their relations to expenditure decisions, employment, production and prices.

James Tobin’s Principal Achievements
James Tobin‘s achievements cover a broad spectrum of economic research. He has made substantial contributions in such widely differing areas as econometric methods and strictly formalized risk theory, the theory of household and firm behaviour, general macro theory and applied analysis of economic policy. His most outstanding and significant research contribution, for which he has been awarded the Nobel Memorial Prize in Economics for 1981, belongs to the theory of financial markets and their relation to consumption and investment decisions, production, employment and prices.

Tobin’s most important contributions are based on a theory which describes how individual households and firms determine the composition of their assets. This theory, of which he is one of the foremost originators, is known as portfolio selection theory. Tobin has developed these ideas into a general equilibrium theory for financial and real assets and analyzed the interaction between financial and real markets. An essential component in this analysis is the study of transmission mechanisms which transfer changes on financial markets to households’ and firms’ expenditure decisions. This classic problem in economic research had, thus far, not been dealt with satisfactorily and conclusively. Tobin’s studies constitute a major breakthrough in the integration of real and financial conditions in central economic theory.

Portfolio Selection Theory
Portfolio selection theory is used to study households’ and firms’ decisions to hold different real and financial assets, and, simultaneously, incur debts. Tobin shows how these decisions are governed by weighing risk and expected rate of return. Unlike many other theorists in the field, Tobin does not confine his analysis solely to money, but considers the entire range of assets and debts.

Other economists who have contributed to portfolio selection theory have mainly been concerned with indicating rules for rational investment decisions. Tobin has aimed at providing a basis for understanding how subjects actually behave when they acquire different assets and incur debts. The direct result is a description and analysis of financial markets and flows in the economy. The primary ambition is to bring out the important components which have, thus far, been lacking in the analysis of impulses from financial to real markets.

The Relation between Financial and Real Markets – or the “Transmission Mechanism”
Tobin emphasizes the effect of financial events on the demand for real assets, i.e., investments and consumer demand. In this context, he has pursued two fundamental issues. The first is how monetary and fiscal policy measures, such as changes in tax rates or central bank purchases and sales of government bonds and treasury bills, affect national income – the “transmission mechanism”. The second concerns the factors which determine how a change in nominal national income brought about through monetary and fiscal policy measures will be distributed among changes in production volume and in price level. In order to answer the latter question, Tobin turned his attention to the problem of wage formation. Owing to rigid wages in the short run, changes in demand on the commodity and labor markets lead to variations in employment rather than changes in price level and the inflation rate. Rigidity in wage formation also makes it difficult, in practice and in the short run, for households and firms to adjust their plans in accordance with new information. This is the reason why the theory of “rational expectations”, which is based on the possibility for this kind of adjustment and has grown so important in the current economic policy debate, has been highly criticized by Tobin.

By examining a broad spectrum of assets and debts, Tobin’s analysis of the transmission mechanism extends the channels of contact between financial markets and real expenditure decisions as compared to the studies of other researchers who have dealt with similar questions. According to Tobin, the effects do not arise through a “general” interest rate level or a money stock defined in some way but through the financial structure as a whole. Various institutional conditions are also taken into account. One of the most important aspects neglected by earlier researchers is the condition whereby the financial system is not comprised mainly of banks, but of numerous and diverse institutions with varying portfolio selection policies.

By designating the channels of contact between financial and real phenomena, Tobin has indicated, theoretically and empirically, the effects of changes in the real value of financial assets on the volume of consumption. A particularly important aspect is the analysis of factors that affect firms’ real investments. Tobin has succeeded in reformulating an earlier hypothesis that these investments are strongly affected by the relation between the market value of existing real capital and the acquisition cost of corresponding, newly-produced real capital. If the prices of existing real capital, such as share prices, decline when the acquisition costs of new real capital are given or rising, then investments are counter-acted. This relation is confirmed by recent development in several countries.

On the basis of his examination of the financial system and transmission mechanisms, Tobin has carried out thorough analyses of economic conditions and stabilization policy during recent decades. The significance of Tobin’s portfolio selection theory and analysis of financial markets is heightened by the fact that they have proved useful in areas which he had not conceived of when he constructed his theory. One pertinent example is the explosive trend in the analysis of balance of payments and exchange rates during the 1970s which is partly based on Tobin’s model.

Tobin’s Influence
Tobin’s creative and extensive work on the analysis of financial markets and the transmission mechanisms between financial and real phenomena has unquestionably inspired substantial research during the 1970s on the effects of monetary policy, the implications of government budget deficits and stabilization policy in general. The lively and qualified research in progress in these areas is, to a large extent, based on Tobin’s fundamental contributions. His efforts have also initiated research in related fields such as balance-of-payments analysis and the study of economic growth. Tobin’s contributions will, in all probability, continue to stimulate economic research for a long time to come. Few economic researchers of today could be said to have gained so many followers or exerted such influence on contemporary research.