Americans Robert Hall and Michael Woodford were awarded the Nobel economics prize Monday for their work on how monetary and fiscal policy can better stabilise disruptive economic fluctuations.
The two were honoured for developing new models for managing recessions and other crises that fail to respond to traditional tools.
"On the basis of these models, well-timed fiscal and monetary policy measures can reduce the economy's peaks and troughs," the jury said.
The Royal Swedish Academy of Sciences explained in a statement that ever since John Maynard Keynes formulated his economic theories almost a century ago, "stabilisation" policies had long let officials boost economic growth when needed.
But during the oil shocks in the 1970s, the Keynesian models that governed when and how action should be taken no longer worked.
"Rather than basing the models on statistical links between macroeconomic variables, such as inflation, production and consumption, they chose to build them on a microeconomic foundation," the jury said.
Hall and Woodford's models include an "understanding for how the total mass of individual households and businesses affect the economy through their actions", it said.
A fundamental aspect of this is the understanding that households are forward-looking when making decisions about spending or saving.
This means the way governments and central banks communicate their policies can influence people's views of the future when making such decisions.
In 1978, Hall, now 83 and a professor at Stanford University, published a seminal article on consumption, which the academy described as "something of a eureka moment" and his work then became key to the development of modern research on consumption.
In 2003, Woodford published a book where he presented a "New Keynesian macro model built upon microfoundations," the academy said.
"The laureates' work has provided us with a stable theoretical foundation for the models that are now used by central banks and governments around the world," John Hassler, chair of the prize-awarding committee, said in a statement.
"It's a staggering piece of news," Woodford told the Nobel Foundation in an interview after the announcement.
Woodford, who was born in 1955 and is a professor at Columbia University, said he was preparing for an exam for his students.
"They're probably hoping I'll cancel the exam," he said and started laughing. "I don't know if I should."
A concrete example of his work implemented in practice was when the 2008 financial crisis created a situation where "traditional tools of monetary policy were not really adequate to deal with the problem of restoring economic activity," Woodford told reporters via phone during the announcement of the prize, noting that interest rates were already lowered to zero in many countries.
One of the new approaches employed by central banks was to start making "more explicit statements" on where they believed guiding interest rates were headed in the future, which continues to this day.
"I think it did contribute to better stabilisation. It didn't magically solve the problem, but I think it was an important contribution," Woodford said.
The decision to honour work on monetary policy comes as the US Federal Reserve, the United States central bank -- which recently hiked rates to combat inflation -- faces unprecedented pressure from President Donald Trump to cut interest rates.
Federal Reserve chair Kevin Warsh, who assumed office in May, has also revamped the central bank's communication strategy.
Warsh has reduced transparency around Fed discussions on monetary policy and stepped away from providing roadmaps of potential future actions, arguing markets should react to the actual data rather than analysing the wording of central bank statements.
"I think it's very appropriate to periodically reassess these things," Woodford told AFP in an interview, noting it was not yet clear exactly what the new communication strategy would end up being.
Woodford also noted that the approach developed following the 2008 financial crisis "was developed in a situation that was certainly very different from where we find ourselves right now."
The economics prize is the only Nobel not among the original five created in the will of Swedish scientist Alfred Nobel, who died in 1896.
It was instead created through a donation from the Swedish central bank in 1968, but like the Nobels in chemistry and physics, the Royal Swedish Academy of Sciences chooses the winner using the same selection process.
Like the other Nobels, the economics prize consists of a diploma, a gold medal and a $1.2 million cheque.