Robert E. Lucas
Robert Lucas was awarded the 1995 Nobel Prize in economics “for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy.” More than any other person in the period from 1970 to 2000, Robert Lucas revolutionized macroeconomic theory. His work led directly to the pathbreaking work of finn kydland and edward prescott, which won them the 2004 Nobel Prize.
Before the early 1970s, wrote Lucas, “two very different styles of macroeconomic theory, both claiming the title of Keynesian economics, co-existed.” One was an attempt to make macroeconomics fit with standard microeconomics. The problem with this was that such models could not be used to make predictions. The other style was macroeconometric models (see forecasting and econometric models) that could be fit to data and used to make predictions but that did not have a clear relationship to economic theory. Many economists were working to unify the two, but economists themselves saw the results as unsatisfactory.
Lucas thought he could do better. His major innovation in his seminal 1972 article was to get rid of the assumption (implicit and often explicit in virtually every previous macro model) that government policymakers could persistently fool people. Economists milton friedman and Edmund Phelps had pointed out that there should be no long-run trade-off between unemployment and inflation; or, in economists’ jargon, that the long-run phillips curve should be vertical.1 They reasoned that the short-run trade-off existed because when the government increased the growth rate of the money supply, which increased prices, workers were fooled into accepting wages that appeared higher in real terms than they really were; they accepted jobs sooner than they otherwise would have, thus reducing unemployment. Lucas took the next step by formalizing this thinking and extending it. He pointed out that in standard microeconomics, economists assume that people are rational. He extended that assumption to macroeconomics, assuming that people would come to know the model of the economy that policymakers use; thus the term “rational expectations.” This meant that if, say, the government increased the growth rate of the money supply to reduce unemployment, it would work only if the government increased money growth more than people expected, and the sure long-term effect would be higher inflation but not lower unemployment. In other words, the government would have to act unpredictably.
In a 1976 article he introduced what is now known as the “Lucas critique” of macroeconometric models, showing that the various empirical equations estimated in such models were from periods where people had particular expectations about government policy. Once those expectations changed, as his theory of rational expectations said they would, then the empirical equations would change, making the models useless for predicting the results of different fiscal and monetary policies. So, for example, if an econometric model showed that for some time period a three-percentage-point drop in inflation was accompanied by a two-percentage-point increase in unemployment, one could not use this correlation to predict the effect of a future three-percentage-point drop in inflation, because people’s expectations would not be the same as they were in the time period for which this relation was estimated. One important implication of Lucas’s work, which was confirmed by Thomas Sargent,2 is that a government that is credible—that is, a government that makes itself understood and believed—can quickly end a major inflation without a big increase in unemployment. The reason: government credibility will cause people to quickly adjust their expectations. The key to that credibility, wrote Sargent, is fiscal policy. If governments commit to balanced budgets, then one of their main motives for inflation is gone (see hyperinflation).
Not all macroeconomists have agreed with Lucas, but all have found themselves needing to confront his critique in some way. Although many economists in the 1970s, for example, thought that Lucas had pounded the final nail in the Keynesian coffin, Keynesians responded with models that assume rational expectations (see new keynesian economics).
In his Nobel lecture, one of the most readable Nobel economics lectures of the last twenty years, 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.3
Lucas has also been one of the leaders in the field of economic growth. In “On the Mechanics of Economic Development” (1988), he helped break down the barrier that had existed between economic development economics (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. Lucas wrote:
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 also did important work on the optimal tax structure. His work led him to change a fundamental belief. In the early 1960s, he had believed that “the single most desirable change in the U.S. tax structure would be the taxation of capital gains as ordinary income.” By 1990 he believed that “neither capital gains nor any of the income from capital should be taxed at all.” He estimated that eliminating capital income taxation would increase the U.S. capital stock by about 35 percent. This belief in low or zero taxation of capital gains is often attributed to believers in so-called supply-side economics. Lucas wrote, “The supply side economists, if that is the right term for those whose research we have been discussing, have delivered the largest genuinely free lunch that I have seen in 25 years of this business, and I believe we would be a better society if we followed their advice.”4
Politically, Lucas is libertarian. Asked by an interviewer in 1982 whether there is social injustice, Lucas replied, “Well, sure. Governments involve social injustice.”5 Asked by another interviewer in 1993 to name the important issues on the economic frontier, Lucas answered, “In economic policy, the frontier never changes. The issue is always mercantilism and government intervention vs. laissez-faire and free markets.”6
An interesting side note: when Lucas and his wife, Rita, got a divorce in 1988, she negotiated for 50 percent 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—or at least correct—expectations.
Lucas earned his B.A. in history in 1959 and his Ph.D. in economics in 1964, both at the University of Chicago. From 1963 to 1974, he was an economics professor at Carnegie Institute of Technology and Carnegie Mellon University. From 1974 to the present, he has been a professor of economics at the University of Chicago.
About the Author
David R. Henderson is the editor of The Concise Encyclopedia of Economics. He is also an emeritus professor of economics with the Naval Postgraduate School and a research fellow with the Hoover Institution at Stanford University. He earned his Ph.D. in economics at UCLA.
Milton Friedman, “The Role of Monetary Policy,” American Economic Review 58 (1968): 1–17; Edmund S. Phelps, “Money Wage Dynamics and Labor Market Equilibrium,” Journal of Political Economy 76 (1968): 687–711.
Thomas Sargent, “The Ends of Four Big Inflations,” chap. 3 in Sargent, Rational Expectations and Inflation (New York: Harper and Row, 1986).
Lucas, “Supply-Side Economics,” p. 314.
Arjo Klamer, Conversations with Economists (Totowa, N.J.: Rowman and Allanheld, 1983), p. 52.
Interview with Robert E. Lucas Jr., The Region, Federal Reserve Bank of Minneapolis (June 1993), online at: www.minneapolisfed.org/pubs/region/93-06/int936.cfm.