History of Economic Thought Robert Lucas (Born September 15, 1937)

Background – Influenced by – Contributions – Impact – Critique – Questions Robert Lucas American Economist and 1995 Nobel Laureate "for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy" Lucas 9/17/2018

Early Life, Education Born in 1937 in Yakima, Washington Background – Influenced by – Contributions – Impact – Critique – Questions Early Life, Education Born in 1937 in Yakima, Washington B.A. in History (1959) and Ph.D. in Economics (1964) from University of Chicago. Recognized his interest in economics when taking courses in Economic History and audited an economic theory course at University of Berkeley. Taught at Tepper School of Business at Carnegie Mellon University from 1963 to 1974. Lucas 9/17/2018

Background – Influenced by – Contributions – Impact – Critique – Questions Work From 1975 to present, he has been a faculty member at University of Chicago. Lucas was Chair of Economics (1986-1988), editor of Journal of Political Economy (1988-2002) Elected to be president of American Economic Association (2001), president of Econometric Society (1997). Lucas 9/17/2018

Influences David Hume Paul Samuelson Milton Friedman John Muth Background – Influenced by – Contributions – Impact – Critique – Questions Influences David Hume Paul Samuelson Milton Friedman John Muth Lucas 9/17/2018

David Hume (1711-1776) Scottish philosopher, historian, and economist. Background – Influenced by – Contributions – Impact – Critique – Questions David Hume (1711-1776) Scottish philosopher, historian, and economist. Observed early on that an increase in the money supply lead to only short run real effect. Was mentioned 35 times during Lucas Nobel speech. Lucas 9/17/2018

Background – Influenced by – Contributions – Impact – Critique – Questions Paul Samuelson (1915 -2009) Countless quantitative and qualitative economic contributions. Lucas came across Samuelson’s Foundations of Economic Analysis and spent the summer trying to understand. Internalized Samuelson’s style and economic reasoning. Lucas 9/17/2018

Background – Influenced by – Contributions – Impact – Critique – Questions Milton Friedman (1912 – 2006) One of the most influential economists of the 20th century. Taught Robert Lucas at University of Chicago where he was a professor from 1946-1977. Lucas tried to rewrite Friedman’s lectures using Samuelson’s structure. Lucas 9/17/2018

Background – Influenced by – Contributions – Impact – Critique – Questions John Muth (1930 – 2005) Muth, John F. "Rational expectations and the theory of price movements." Econometrica: Journal of the Econometric Society (1961): 315-335. Lucas 9/17/2018

Contributions Rational Expectations Lucas Critique Background – Influenced by – Contributions – Impact – Critique – Questions Contributions Rational Expectations Lucas Critique Lucas, Robert E. "On the mechanics of economic development." Econometric Society Monographs 29 (1998): 61-70. Lucas Paradox Lucas 9/17/2018

Rational Expectations Background – Influenced by – Contributions – Impact – Critique – Questions Rational Expectations Phillips Curve - a diagram that shows the relationship between Inflation and Unemployment in the economy at different times. Lucas 9/17/2018

Rational Expectations Background – Influenced by – Contributions – Impact – Critique – Questions Rational Expectations Lucas 9/17/2018

Rational Expectations Background – Influenced by – Contributions – Impact – Critique – Questions Rational Expectations After observing the Phillips Curve in the 50’s and 60’s, policy makers concluded that there is a stable negative relationship b/w inflation and unemployment. The Phillips Curve provided a menu for economic policy (they thought): you can choose lower unemployment (boost the economy) by increasing inflation. Lucas 9/17/2018

Rational Expectations Background – Influenced by – Contributions – Impact – Critique – Questions Rational Expectations The Keynesian model is modified (AD-AS) so that it predicts negative relationship b/w inflation (or prices) and unemployment. Lucas 9/17/2018

Rational Expectations Background – Influenced by – Contributions – Impact – Critique – Questions Rational Expectations Economists engaged in estimating the Phillips Curve, and central banks tempted to use inflation to “boost” the economy permanently. Lucas 9/17/2018

Edmund Phelps (Nobel Prize in Economics 2006) Background – Influenced by – Contributions – Impact – Critique – Questions Edmund Phelps (Nobel Prize in Economics 2006) He introduced a crucial notion of “expected inflation” His conclusion was that there is no long-run tradeoff between inflation and unemployment.

Rational Expectations Background – Influenced by – Contributions – Impact – Critique – Questions Rational Expectations Theoretical relationship b/w inflation and unemp. 𝜋 𝑡 − 𝜋 𝑡 𝑒 =−𝛽( 𝑢 𝑡 − 𝑢 𝑛 ) 𝜋 𝑡 𝑒 - expected inflation 𝑢 𝑛 - natural rate of unemp. Lucas 9/17/2018

Rational Expectations Background – Influenced by – Contributions – Impact – Critique – Questions Rational Expectations Phelps’ insight and his emphasis of the expected inflation revolutionized the way monetary policy is conducted. Phelps switched the discussion from the permanent trade- off between inflation and unemployment to discussion about intertemporal trade-off (between lowering unemployment now but suffering from high inflation in the future). Lucas 9/17/2018

Rational Expectations Background – Influenced by – Contributions – Impact – Critique – Questions Rational Expectations Lucas contribution: effectiveness of monetary stimulus depends on how people form expectations about inflation, 𝜋 𝑡 𝑒 . Phelps: 𝜋 𝑡 𝑒 = 𝜋 𝑡−1 , “backward-looking” expectation. Lucas: 𝜋 𝑡 𝑒 =𝐸( 𝜋 𝑡 | Ω 𝑡−1 ), where Ω 𝑡−1 is all the information available at time 𝑡−1. These are “rational- expectations”. Lucas 9/17/2018

Rational Expectations Background – Influenced by – Contributions – Impact – Critique – Questions Rational Expectations Example: suppose 𝛽=1, 𝑢 𝑛 =5, 𝜋 𝑡 𝑒 = 𝜋 𝑡−1 (backward- looking expectations). Theoretical relationship between inflation and unemployment is: 𝜋 𝑡 − 𝜋 𝑡 𝑒 =−𝛽( 𝑢 𝑡 − 𝑢 𝑛 ) 𝑢 𝑡 = 𝑢 𝑛 + 𝜋 𝑡 𝑒 − 𝜋 𝑡 Suppose that the FED creates inflation of 1% until period 3 and then increases the inflation permanently to 2%. Show the time path of inflation, expected inflation and unemployment from period 1 on. Lucas 9/17/2018

Rational Expectations Background – Influenced by – Contributions – Impact – Critique – Questions Rational Expectations Backward Looking Expectations: 𝜋 𝑡 𝑒 = 𝜋 𝑡−1 Lucas 9/17/2018

Rational Expectations Background – Influenced by – Contributions – Impact – Critique – Questions Rational Expectations Rational Expectations: 𝜋 𝑡 𝑒 = 𝜋 𝑡 Lucas 9/17/2018

Rational Expectations Background – Influenced by – Contributions – Impact – Critique – Questions Rational Expectations Almost rational expectations 𝜋 𝑡 𝑒 ≈ 𝜋 𝑡−1 Lucas 9/17/2018

Rational Expectations Background – Influenced by – Contributions – Impact – Critique – Questions Rational Expectations Phelps emphasized the short-run tradeoff between inflation and unemployment, recognizing that there is no tradeoff in the long-run. Lucas demonstrated that with rational expectations, inflationary policy may not be effective in reducing unemployment, even in the short-run. Lucas 9/17/2018

Background – Influenced by – Contributions – Impact – Critique – Questions Lucas Critique Methodology of macroeconomic policy evaluation in the 70s - large-scale macroeconometric models, based on Keynesian model. Used large amounts of data and based forecasts on past correlations instead of theoretical relations. Lucas critique: estimated parameters are not policy- invariant, i.e. change with economic policy (fiscal, monetary). Lucas 9/17/2018

Background – Influenced by – Contributions – Impact – Critique – Questions Lucas Critique Example: Keynesian Model. Consumption: 𝐶= 𝐶 0 +𝑀𝑃𝐶 𝑌−𝑇 Investment: 𝐼= 𝐼 0 +𝑀𝑃𝐼∙𝑌 Government: 𝐺= 𝐺 0 , Taxes: 𝑇= 𝑇 0 +𝑡𝑌 Fiscal policy multiplier: 𝑚 𝑘 = 1 1−𝑀𝑃𝐶 1−𝑡 −𝑀𝑃𝐼 Lucas 9/17/2018

Background – Influenced by – Contributions – Impact – Critique – Questions Lucas Critique Fiscal policy multiplier: 𝑚 𝑘 = 1 1−𝑀𝑃𝐶 1−𝑡 −𝑀𝑃𝐼 Example: 𝑚 𝑘 = 1 1−0.75 1−0.25 −0.1 =2. 963 $1 of government spending increases equilibrium output by nearly $3, if 𝑴𝑷𝑪,𝑴𝑷𝑰 don’t change. Lucas 9/17/2018

Background – Influenced by – Contributions – Impact – Critique – Questions Lucas Critique Lucas showed that policy evaluations based on large- scale macroeconometric models are invalid, because the estimated parameters are not policy-invariant. Conclusions: Must use models with microfoundations, such as Ramsey model. Must estimate “deep” parameters, which are policy invariant (preferences and technology). Lucas 9/17/2018

Background – Influenced by – Contributions – Impact – Critique – Questions Lucas Critique Ramsey Model: max 𝑐 𝑡 , ℎ 𝑡 , 𝑥 𝑡 , 𝑘 𝑡+1 𝑡=0 ∞ 𝑡=0 ∞ 𝛽 𝑡 𝛼 ln 𝑐 𝑡 + 1−𝛼 ln (1− ℎ 𝑡 ) 𝑠.𝑡. 1+ 𝜏 𝑐𝑡 𝑐 𝑡 + 1+ 𝜏 𝑥𝑡 𝑥 𝑡 = 1− 𝜏 𝑤𝑡 𝑤 𝑡 ℎ 𝑡 + 1− 𝜏 𝑘𝑡 𝑟 𝑡 𝑘 𝑡 + 𝜏 𝑡 ∀𝑡 𝑘 𝑡+1 = 1−𝛿 𝑘 𝑡 + 𝑥 𝑡 Here 𝛼,𝛽 are policy invariant (preference parameters). Lucas 9/17/2018

Lucas Critique Example 1 Background – Influenced by – Contributions – Impact – Critique – Questions Lucas Critique Example 1 Fort Knox has never been robbed Because it’s never been robbed, under backward- looking expectations, the guards are unnecessary. However, the safety of fort Knox depends on the presence of the guards. Historical data can’t show the effect of removing the guards, but rational expectations can. Lucas 9/17/2018

Lucas Critique Example 2 Background – Influenced by – Contributions – Impact – Critique – Questions Lucas Critique Example 2 Some voters claimed that Clinton would win the elections if we had majority vote. Based on Lucas Critique however, if we changed the rules of the vote, then voters would change their behavior. Republicans in predominantly democratic state may have higher turnover, and vice versa, so we don’t know who would win. Lucas 9/17/2018

Impact on Monetary policy Background – Influenced by – Contributions – Impact – Critique – Questions Impact on Monetary policy Following Lucas work on rational expectations, modern central banks focus on establishing trust and credibility. Bernanke 2005: “Influencing policy expectations for the more distant future may be more difficult. However, the FOMC has two general ways to help financial market participants divine the long-run course of policy… Lucas 9/17/2018

Impact on Monetary policy Background – Influenced by – Contributions – Impact – Critique – Questions Impact on Monetary policy Bernanke 2005: “First, to the extent practical, the FOMC strives to be consistent in how it responds to particular configurations of economic conditions and transparent in explaining the reasons for its response. By building a consistent track record, the FOMC increases its own predictability as well as public confidence in its policies… Lucas 9/17/2018

Impact on Monetary policy Background – Influenced by – Contributions – Impact – Critique – Questions Impact on Monetary policy Bernanke 2005: “Second, more generally, comments by FOMC officials about the Committee's general policy framework, including the Committee's economic objectives and members' views about the channels of monetary policy transmission and the structure of the economy, help the public deduce how policy is likely to respond to future economic circumstances.” It is all about 𝜋 𝑡 𝑒 =𝐸( 𝜋 𝑡 | 𝛺 𝑡−1 ) Lucas 9/17/2018

Impact on Economic Research Background – Influenced by – Contributions – Impact – Critique – Questions Impact on Economic Research Lucas critique revolutionized the macroeconomic research methodology – from estimating large-scale macroeconometric models to models with microfoundations. Lucas 9/17/2018

Background – Influenced by – Contributions – Impact – Critique – Questions Wrong Prediction? “the central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.” Lucas, 2003, in presidential address to the American Economic Association. Lucas 9/17/2018

Background – Influenced by – Contributions – Impact – Critique – Questions Rational expectations theory implies that people always make correct forecasts. True or False? Rational expectations implies that all agents have the same information. True of False? Lucas 9/17/2018

Questions Solow Model Ramsey Model Background – Influenced by – Contributions – Impact – Critique – Questions Questions Which of the following theories are lacking micro- foundations: Keynesian Model Solow Model Ramsey Model Walras’ Model of General Equilibrium 𝑌 𝑖 = 𝛽 0 + 𝛽 1 𝑋 1𝑖 +…+ 𝛽 𝑘 𝑋 𝑘𝑖 + 𝑢 𝑖 Lucas 9/17/2018

Main Publications Lucas, Robert E. "Expectations and the Neutrality of Money." Journal of economic theory 4, no. 2 (1972): 103- 124. Lucas, Robert E. "Econometric policy evaluation: A critique." In Carnegie-Rochester conference series on public policy, vol. 1, pp. 19-46. North-Holland, 1976. Lucas 9/17/2018