A guiding light

Nobel-winning macroeconomist Robert E Lucas, Jr (known as Bob Lucas) passed away on May 15, 2023 at the age of 85. As a teacher and lifelong student of macroeconomics, I feel compelled to pay my tribute to this remarkable economist who revolutionised the thinking of macroeconomists with his ground-breaking paper, ‘Econometric Policy Evaluation’, published in 1976, which was subsequently known as Luca’s critique. This influential article not only shaped the field of academic macroeconomics but also had a profound impact on the policymaking of governments and central banks worldwide.

Before Lucas wrote this article, governments would often modify their policies without considering the potential effects on people's behaviour. For instance, let us consider a scenario where a government lowers income taxes by 5 per cent to stimulate consumer spending. If taxpayers perceive this tax cut as temporary, they are likely to increase their spending to a lesser extent and save more for future uncertainties compared to if they believe the tax cut is permanent. In other words, if the government aims to achieve a specific impact on spending behaviour, it must consider how people's expectations and behaviour are influenced by such policy changes. Neglecting this aspect can render government policies less effective in stimulating the economy.

To put it more concretely, the cornerstone of Bob Lucas's pioneering work on policy effectiveness is the concept of rational expectations held by citizens. Unless the public is surprised by a policy change, they will not respond to it, rendering the government's policy largely ineffective. This remarkable result was derived by Bob in his seminal paper, ‘Expectations and Neutrality of Money’, written in 1972, wherein he demonstrated that a change in money supply by the Central Bank has real effects on output and employment if the public has imperfect information about monetary policy. Viewed from this perspective, I am not sure whether Bob would have endorsed the current rate hikes by the major Western nations led by the US Federal Reserve Board to combat inflation. This rate hike is based on a mechanical rule popularised by the Stanford economist John Taylor. Central Banks in major Western countries follow this Taylor rule by raising their policy rates to control inflation. In a world of well-informed individuals with rational expectations, this policy rule is expected by the public beforehand and is unlikely to have desirable effects on inflation. In fact, such policies can even have adverse and destabilizing side-effects on the economy, which is seen nowadays in major western countries. Successive rate hikes, instead of cooling inflation, have aggravated the banking front and also added to the distress of mortgage paying households.

Writing about Bob Lucas's work is a monumental and audacious task. I would quickly outline two other areas where Bob changed the macroeconomists' way of thinking. He integrated financial economics with macroeconomics and created a discipline called ‘macro-finance’. Before his seminal ‘Econometrica’ (1978) paper, ‘Asset Prices in an Exchange Economy’, finance was treated as a separate discipline, which was a rather artificial division. We all know that movements in stock markets are connected to the state of the economy. If the economy performs well, stock prices go up. Lucas's paper provides a framework that shows this connectivity between the stock market and the aggregate economy.

The final area where Lucas made a significant contribution is Development Economics by writing another seminal piece in 1988, ‘On the Mechanics of Economic Development’. He addressed the important question of why nations have diverse living standards and growth experiences. The traditional neoclassical growth models are unable to explain this satisfactorily. He introduced the intangible human capital in these models and demonstrated that education and knowledge could be a driver of growth. Before he wrote this paper, development economics was treated as a different field. Lucas integrated this branch with macroeconomics. Following his lead, a new discipline emerged known as ‘macro-development’.

Bob was a real gentleman with a touch of humour. In 2011, when I was visiting the research division of the Federal Reserve Bank of Minneapolis on my sabbatical, he was kind enough to drop into my office to listen to whatever trivial stuff I was working on. When he queried about a feature of my macro model, I said, “Bob it is quite standard nowadays.” He smiled and said, “Don’t utter the word ‘standard’. It is intimidating. You are actually forcing me to believe in what you are doing!”

Bob Lucas created a generation of macroeconomists who will continue to follow in his footsteps and advance the frontier of knowledge in macroeconomics. His contributions are timeless.

The writer is a Professor of Macroeconomics at Durham University, UK. Views expressed are personal