Robert Lucas is a new classical economist and is a Nobel Prize winner in 1995 for developing the theory of rational expectations. He is best known for his development of rational expectations theory and the Lucas critique of macroeconomic policy. Lucas’ study mainly focuses on the implications of the rational expectations theory in macroeconomics.
Theory of Rational Expectations
A vertical Phillips Curve implies that expansionary monetary policy will increase inflation, without boosting the economy. However, Lucas argued that if individuals in the economy are rational, then only unanticipated changes to the money supply will have an impact on output and employment. Otherwise, people will just rationally set their wage and price demands according to their expectations of future inflation as soon as a monetary policy is announced and the policy will only have an impact on prices and inflation rates. In this case, the Phillips Curve is not only vertical in the long run, but also in the short run if policy maker makes unannounced and unpredictable policies.
Lucas Critiques
The Lucas critique, named for Robert Lucas’ work on macroeconomic policymaking, argues that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.
The economic condition is formed by consumer, business, and investor’s behaviours (expectations) based on past data. Expectations will not hold policy changes.
Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models.
Robert Lucas
In other words, changes in a certain factor would affect other factors as well. For example, the government increase tax would result in changes in other economic factors by affecting people’s expectations.
The suggestion of Lucas Critique is that if we want to predict the effect of a policy experiment, we should model the “deep parameters” (relating to preferences, technology and resource constraints) that govern individual behaviour. We can then predict what individuals will do, taking into account the change in policy, and then aggregate the individual decisions to calculate the macroeconomic effects of the policy change.
The Lucas critique was influential not only because it cast doubt on many existing models, but also because it encouraged macroeconomists to build micro-foundations for their models. Microfoundations had always been thought to be desirable; Lucas convinced many economists they were essential. Real Business Cycle economists, starting with Finn Kydland and Edward Prescott, focused their research on using micro-foundations to formulate macroeconomic models. Contemporary macroeconomic models micro-founded on the interaction of rational agents are often called dynamic stochastic general equilibrium (DSGE) models.
Additional
The Lucas Critiques criticised the idea of Keynesian economics that treat the economy as a machine, and apply fiscal and monetary policy to affect the economic operations. Instead, the public sector should consider how private sectors actively react to the policy. For example, if the policy-making (monetary policy such as changes in the interest rate and wage rates) is forecasted by private sectors, then the impacts would be eliminated or reduced, because private sectors would react to the changes by e.g. saving.
Lucas considered that the reason the Keynesian policy works in the short run is there are too many noises in the markets so that private sectors cannot make rational expectations.