The Nobel series: Proponent of rational expectations

The Nobel Prize in Economic Sciences in 1995 was awarded to Robert E Lucas Jr of the University of Chicago "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 major in his undergraduate studies was history which he finished in 1959 from the University of Chicago. After this, Lucas joined the University of California at Berkeley to pursue higher studies but had to return to Chicago in 1960 due to financial reasons. He ultimately finished his PhD in economics from the University of Chicago in 1964. He wrote his dissertation 'Substitution between Labour and Capital in US Manufacturing: 1929–1958' under the guidance of Gregg Lewis and Dale Jorgensen. Lucas became a faculty member at Carnegie Mellon University after his PhD. He stayed there till 1975, before his return to the University of Chicago.

In this paper, we will discuss the main works of Lucas and see how these apply to policy across the world even today.

Main Works

Lucas is best known for four broad works: a) Developing the theory of rational expectations b) Reinterpreting the critique of the Phillips curve by Friedman and Phelps c) The Lucas critique of macroeconometric models and d) Giving a fresh insight into the analysis of business cycles.

Theory of rational expectations

The theory of rational expectations was first given by Muth in 1961 but it was Lucas in the early 1970s who popularised it by extending the analysis to the whole of the economy. The theory in its simplest form says that economic agents factored in the impact of fiscal and monetary policy in their actions. In other words, Lucas did away with the assumption that the government could fool the people all the time. As the Nobel website tells us:

Instead, rational expectations are genuinely forward-looking. The rational expectations hypothesis means that agents exploit available information without making the systematic mistakes implied by earlier theories. Expectations are formed by constantly updating and reinterpreting this information. Sometimes the consequences of rational expectations formation are dramatic, as in the case of economic policy. The first precise formulation of the rational expectations hypothesis was introduced by John Muth in 1961. But it did not gain much prominence until the 1970s when Lucas extended it to models of the aggregate economy. In a series of path-breaking articles, Lucas demonstrated the far-reaching consequences of rational expectations formation, particularly concerning the effects of economic policy and the evaluation of these effects using econometric methods, that is, statistical methods specifically adapted for examining economic relationships. Lucas also applied the hypothesis to several fields other than macroeconomics.

He used this theory to reinterpret the Phillips curve relationship between inflation and unemployment.

Application to Phillips Curve

As we saw above, Lucas relaxed the assumption that the government could fool all the people all the time. He applied this effectively to the reinterpretation of the Phillips curve. We may recall that the Phillips curve in its original form had postulated an inverse relationship between inflation and unemployment. The argument was that to lower unemployment rates, the government would pursue expansionary fiscal policies; however, the cost for this would be higher inflation. In other words, there was a trade-off between lower unemployment and higher inflation. Milton Friedman and Edmund Phelps pointed out that this trade-off would exist only in the short run. In the long run, there would be no such trade-off and, consequently, the Phillips curve would be vertical. They argued that in the short run, when the government pursued expansionary fiscal policy and raised money supply, the workers accepted jobs since the nominal wages were higher (even though the real wages were lower) thereby reducing unemployment. Freidman and Phelps thought that this won't last in the long run since the workers would be wiser and they would realise that real wages had not risen after all. In other words, they would 'adapt' their expectations to the new reality.

Lucas extended the arguments of Friedman and Phelps and weaved them into a theoretical framework. In his paper of 1972, Lucas argued that no stabilisation policy could reduce unemployment in the long run because of rational expectations of the people. As the Nobel website tells us:

Lucas used the rational expectations hypothesis to provide the first theoretically satisfactory explanation for why the Phillips curve could be sloping in the short run but vertical in the long run. In other words, regardless of how it is pursued, stabilisation policy cannot systematically affect long-run employment. Lucas formulated an ingenious theoretical model which generates time series such that inflation and employment indeed seem to be positively correlated. A statistician who studies these time series might easily conclude that employment could be increased by implementing an expansionary economic policy. Nevertheless, Lucas demonstrated that any endeavour, based on such policy, to exploit the Phillips curve and permanently increase employment would be futile and only give rise to higher inflation. This is because agents in the model adjust their expectations and hence price and wage formation to the new, expected policy. Experience during the 1970s and 1980s has shown that higher inflation does not appear to bring about a permanent increase in employment. This insight into the long-run effects of stabilisation policy has become a commonly accepted view; it is now the foundation for monetary policy in a number of countries in their efforts to achieve and maintain a low and stable inflation rate.

Hence, the rise in the growth rate of the money supply to reduce unemployment would work only if the government increased money growth more than people expected. In other words, the government would have to act unpredictably.

The "Lucas Critique"

The above analysis of the Phillips curve warns us against a simplistic application of economic theories to policy problems. More specifically, Lucas warned against relying on the macroeconometric models used to construct the Phillips curve. In his paper published in 1976, he criticised such models and showed that these models relied on empirical equations from past periods when people had particular expectations from the government policy. In other words, these equations assumed relations as 'structural' while they were in fact determined by the past policy. Hence, as expectations change as per his theory of rational expectations, these empirical equations must also change; or else, the older models would be useless. The Lucas critique presented a huge challenge for policy-makers. As the Nobel website tells us:

The Lucas critique has had a profound influence on economic-policy recommendations. Shifts in economic policy often produce a completely different outcome if the agents adapt their expectations to the new policy stance. Nowadays, when evaluating the consequences of shifts in economic-policy regimes – like a new exchange rate system, a new monetary policy, a tax reform or new rules for unemployment benefits – it is more or less self-evident to consider changes in the behaviour of economic agents due to revised expectations.

A possible solution to the Lucas critique was provided by Lucas himself: to formulate models which are "equilibrium models" with rational expectations. In such models, all important variables are endogenous, i.e., they should be determined within the model on the basis of interaction among rational agents who have rational expectations and operate in a well-specified economic environment. Further, microeconomic foundations, i.e., the individual agents' decision problems have to be completely accounted for in the model.

One important implication of Lucas's work, which was confirmed by Thomas Sargent, is that a government that is credible — that makes itself understood and believed — can quickly end a major inflation without a big increase in unemployment. The reason was that the government's credibility will cause people to quickly adjust their expectations. The key to that credibility, wrote Sargent, is a credible fiscal policy with balanced budgets.

In his Nobel lecture, Lucas summed up his and others' contributions in the 1970s:

The main finding that emerged from the research of the 1970s is that anticipated changes in money growth have very different effects from unanticipated changes. Anticipated monetary expansions have inflation tax effects and induce an inflation premium on nominal interest rates, but they are not associated with the kind of stimulus to employment and production that Hume described. Unanticipated monetary expansions, on the other hand, can stimulate production as, symmetrically, unanticipated contractions can induce depression.

Analysis of business cycles

Lucas' work on business cycles bought a new way to interpret these cycles. Lucas argued that the "recurrent character of business cycles", as interpreted by economists like Friedrich von Hayek, should have been persisted with. According to Lucas, the cyclical phenomenon of business cycles could be incorporated into the Arrow-Debreu general equilibrium framework. It may be recalled that the equilibrium theory of business cycles initially relied on the assumption of completely flexible prices and immediate adjustment to equilibrium on goods and labour markets with perfect competition. Lucas' contribution was that his model would work with market failures (such as information asymmetry and imperfect competition) as well as inflexible prices. Lucas' work was captured in 'Studies in Business-Cycle Theory' (1981) and 'Models of Business Cycles' (1987).

Other Works

In later years, Lucas worked on other issues such as economic growth and taxation. In an article in 1988, titled 'On the Mechanics of Economic Development', he helped break down the barrier that had existed between economic development (applied to poor countries) and economic growth (the study of growth in already rich countries). He argued that the same basic economic framework should apply to each and that it was crucial to understand how poor countries could grow. To quote Lucas:

Is there some action a government of India could take that would lead the Indian economy to grow like Indonesia's or Egypt's? If so, what, exactly? If not, what is it about the "nature of India" that makes it so? The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else. (Lucas 1988, p. 5; italics in original)

Lucas is also known for his Lucas-Uzawa model which explains long-run economic growth as dependent on human capital accumulation, and the Lucas Paradox which asks why capital does not appear to flow to regions of the globe where capital is relatively scarce (and thus receives a higher rate of return) as neoclassical growth theory would predict.

On taxation, he worked on what the optimal tax rate and structure should be. He changed his view on taxing capital gains in the 1990s and believed that neither capital gains nor income from capital in the USA should be taxed. He estimated that eliminating capital income taxation would increase the US capital stock by about 35 per cent. This belief in low or zero taxation of capital gains is often attributed to supply side economics.

Lucas edited or coedited several economic journals and served for a time as president of the American Economic Association and the Econometric Society. In 2001, Lucas published 'Lectures on Economic Growth' — a collection of his writings on economic growth.

Conclusion

Lucas is considered as one of the most influential macroeconomists since the 1960s. His work on rational expectations and his methods, which allowed general equilibrium to be incorporated into the theory of business cycles, are considered landmarks. His theory of rational expectations also provided microfoundation to the study of macroeconomics — something that economists had been struggling with for a while. His work led to a new field called rational expectations macroeconometrics, which is widely applied to analysis of the impact of fiscal and monetary policy.

On rational expectations, I end with an interesting anecdote: when Lucas and his wife, Rita, got a divorce in 1988, she negotiated for 50 per cent of any Nobel Prize money that he might receive, with an October 31, 1995, expiration date on this clause. He won the prize on October 10, 1995. Economists joked that Lucas's model applied to his wife: she had rational expectations.

The writer is an IAS officer, working as Principal Resident Commissioner, Government of West Bengal. Views expressed are personal