Robert Lucas and the rational expectations revolution

 

Few economists over the past 50 years had as great an impact on macroeconomics as Bob Lucas, who died Monday May 15, 2023 at the age of 85. When Lucas received the 1995 Nobel Prize in Economics, the Prize committee cited him “for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy.”

Lucas’s 1972 paper, “Expectations and the neutrality of money,” (Journal of Economic Theory 4(2), 103-124) set out a coherent theory reconciling the long-run neutrality of money with the short-run non-neutrality of money. He did so by carefully modeling an informational friction that generated expectational errors in the short-run, errors that, because individual firms and households formed expectations rationally, could not persist. In his model, only monetary policy surprises mattered for the real economy. This result had profound implications for monetary policy. Lucas and Sargent summarized these implications in 1978, noting that policy had to be systematic, stating that “… [equilibrium methods] will focus attention on the need to think of policy as the choice of stable rules of the game, well understood by economic agents. Only in such a setting will economic theory help predict the actions agents will choose to take.” Yet policy must also be unpredictable: “the government countercyclical policy must itself be unforeseeable by private agents...while at the same time be systematically related to the state of the economy. Effectiveness, then, rests on the inability of private agents to recognize systematic patterns in monetary and fiscal policy (Lucas and Sargent 1978).

When expectations are formed rationally, having policy be systematic while also being unpredictable is a contradiction. Whatever systematic rule the central bank chose to follow would come to be understood by the public and would then make no difference for the real economy; it would matter for inflation, but not for output or unemployment. This conclusion became known as the policy irrelevance hypothesis.

Lucas offered empirical evidence for his theory in “Some International Evidence on Output-Inflation Tradeoffs.” (American Economic Review, 1973, 63 (3): 326–34). There he showed that evidence on the slope of the output-inflation tradeoff from a cross-section of countries followed “directly from the view that inflation stimulates real output if, and only if, it succeeds in "fooling" suppliers of labor and goods into thinking relative prices are moving in their favor.”

The development of the new Keynesian approach during the 1990s shifted the focus of the non-neutrality of monetary policy from informational frictions to price and wage rigidities. Today’s models are firmly based on rational expectations, relying on nominal rigidities in the form of sticky prices and wages as the rationale for the potentially significant but ultimately temporary effects of monetary policy on the real economy.

Importantly, the emphasis today is that policy must be be systematic and predictable if it is to be effective. As described by Woodford in Interest and Prices: Foundations of a Theory of Monetary Policy (2003, Princeton, NJ: Princeton University Press), “...the central bank’s stabilization goals can be most effectively achieved only to the extent that the central bank not only acts appropriately, but is also understood by the private sector to predictably act in a certain way. The ability to successfully steer private-sector expectations is favored by a decision procedure that is based on a rule, since in this case the systematic character of the central bank’s actions can be most easily made apparent to the public.” (p. 465, emphasis in original).

While Lucas’s model of monetary non-neutrality has largely been replaced, his impact on current policy discussions is still strong. Discussions of monetary policy, whether in theoretical work or in policy practice, continue to stress the importance of policy credibility and of behaving in a systematic fashion. When central bankers emphasize the important role of inflation expectations, the need to anchor expectations, and that a credible commitment to lower inflation will lessen the unemployment costs of anti-inflation policies, they are channeling the fundamental insights of Bob Lucas.