History of Economic Thought Robert Lucas Born September
History of Economic Thought Robert Lucas (Born September 15, 1937)
Background – Influenced by – Contributions – Impact – Critique – Questions Robert Lucas American Economist and 1995 Nobel Laureate Lucas "for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic 11/2/2020 2 analysis and deepened our understanding of
Background – Influenced by – Contributions – Impact – Critique – Questions Early Life, Education • Born in 1937 in Yakima, Washington • B. A. in History (1959) and Ph. D. in Economics (1964) from University of Chicago. • Recognized his interest in economics when taking courses in Economic History and audited an economic theory course at University of Berkeley. • Taught at Tepper School of Business at 11/2/2020 3 Carnegie Mellon University from 1963 to 1974. Lucas
Background – Influenced by – Contributions – Impact – Critique – Questions Work • From 1975 to present, he has been a faculty member at University of Chicago. • Lucas was Chair of Economics (1986 -1988), editor of Journal of Political Economy (19882002) • Elected to be president of American Economic Association (2001), president of Econometric Society (1997). Lucas 11/2/2020 4
Background – Influenced by – Contributions – Impact – Critique – Questions Influences 1. 2. 3. 4. Lucas David Hume Paul Samuelson Milton Friedman John Muth 11/2/2020 5
Background – Influenced by – Contributions – Impact – Critique – Questions David Hume (1711 -1776) • Scottish philosopher, historian, and economist. • Observed early on that an increase in the money supply lead to only short run real effect. • Was mentioned 35 times during Lucas Nobel speech. Lucas 11/2/2020 6
Background – Influenced by – Contributions – Impact – Critique – Questions Paul Samuelson (1915 2009) • Countless quantitative and qualitative economic contributions. • Lucas came across Samuelson’s Foundations of Economic Analysis and spent the summer trying to understand. • Internalized Samuelson’s style and economic reasoning. Lucas 11/2/2020 7
Background – Influenced by – Contributions – Impact – Critique – Questions Milton Friedman (1912 – 2006) • One of the most influential economists of the 20 th century. • Taught Robert Lucas at University of Chicago where he was a professor from 19461977. • Lucas tried to rewrite Friedman’s lectures using Samuelson’s structure. Lucas 11/2/2020 8
Background – Influenced by – Contributions – Impact – Critique – Questions John Muth (1930 – 2005) Muth, John F. "Rational expectations and theory of price movements. " Econometrica: Journal of the Econometric Society (1961): 315335. Lucas 11/2/2020 9
Background – Influenced by – Contributions – Impact – Critique – Questions Contributions 1. Rational Expectations 2. Lucas Critique 3. Lucas, Robert E. "On the mechanics of economic development. " Econometric Society Monographs 29 (1998): 61 -70. 4. Lucas Paradox Lucas 11/2/2020 10
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational Expectations Phillips Curve - a diagram that shows the relationship between Inflation and Unemployment in the economy at different times. Lucas 11/2/2020 11
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational Expectations Lucas 11/2/2020 12
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational Expectations After observing the Phillips Curve in the 50’s and 60’s, policy makers concluded that there is a stable negative relationship b/w inflation and unemployment. The Phillips Curve provided a menu for economic policy (they thought): you can choose lower unemployment (boost the economy) by increasing inflation. Lucas 11/2/2020 13
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational Expectations The Keynesian model is modified (AD-AS) so that it predicts negative relationship b/w inflation (or prices) and unemployment. Lucas 11/2/2020 14
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational Expectations Economists engaged in estimating the Phillips Curve, and central banks tempted to use inflation to “boost” the economy permanently. Lucas 11/2/2020 15
Background – Influenced by – Contributions – Impact – Critique – Questions Edmund Phelps (Nobel Prize in Economics 2006) • He introduced a crucial notion of “expected inflation” • His conclusion was that there is no long-run tradeoff between inflation and unemployment.
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational Expectations • Lucas 11/2/2020 17
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational Expectations Phelps’ insight and his emphasis of the expected inflation revolutionized the way monetary policy is conducted. Phelps switched the discussion from the permanent trade-off between inflation and unemployment to discussion about intertemporal trade-off (between lowering unemployment now but suffering from high inflation in the future). Lucas 11/2/2020 18
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational Expectations • Lucas 11/2/2020 19
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational Expectations • Lucas 11/2/2020 20
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational Expectations Lucas 11/2/2020 21
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational Expectations Lucas 11/2/2020 22
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational Expectations Lucas 11/2/2020 23
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational Expectations • Phelps emphasized the short-run tradeoff between inflation and unemployment, recognizing that there is no tradeoff in the long -run. • Lucas demonstrated that with rational expectations, inflationary policy may not be effective in reducing unemployment, even in the short-run. Lucas 11/2/2020 24
Background – Influenced by – Contributions – Impact – Critique – Questions 2. Lucas Critique Methodology of macroeconomic policy evaluation in the 70 s - large-scale macroeconometric models, based on Keynesian model. Used large amounts of data and based forecasts on past correlations instead of theoretical relations. Lucas critique: estimated parameters are not policy-invariant, i. e. change with economic policy (fiscal, monetary). Lucas 11/2/2020 25
Background – Influenced by – Contributions – Impact – Critique – Questions 2. Lucas Critique • Lucas 11/2/2020 26
Background – Influenced by – Contributions – Impact – Critique – Questions 2. Lucas Critique • Lucas 11/2/2020 27
Background – Influenced by – Contributions – Impact – Critique – Questions 2. Lucas Critique Lucas showed that policy evaluations based on large-scale macroeconometric models are invalid, because the estimated parameters are not policy-invariant. Conclusions: 1. Must use models with microfoundations, such as Ramsey model. 2. Must estimate “deep” parameters, which are Lucas 11/2/2020 28 policy invariant (preferences and technology).
Background – Influenced by – Contributions – Impact – Critique – Questions 2. Lucas Critique • Lucas 11/2/2020 29
Background – Influenced by – Contributions – Impact – Critique – Questions Lucas Critique Example 1 • Fort Knox has never been robbed • Because it’s never been robbed, under backward- looking expectations, the guards are unnecessary. • However, the safety of fort Knox depends on the presence of the guards. • Historical data can’t show the effect of removing the guards, but rational expectations can. Lucas 11/2/2020 30
Background – Influenced by – Contributions – Impact – Critique – Questions Lucas Critique Example 2 • Some voters claimed that Clinton would win the elections if we had majority vote. • Based on Lucas Critique however, if we changed the rules of the vote, then voters would change their behavior. • Republicans in predominantly democratic state may have higher turnover, and vice versa, so we don’t know who would win. Lucas 11/2/2020 31
Background – Influenced by – Contributions – Impact – Critique – Questions Impact on Monetary policy Following Lucas work on rational expectations, modern central banks focus on establishing trust and credibility. Bernanke 2005: “Influencing policy expectations for the more distant future may be more difficult. However, the FOMC has two general ways to help financial market participants divine the long-run course of policy… Lucas 11/2/2020 32
Background – Influenced by – Contributions – Impact – Critique – Questions Impact on Monetary policy Bernanke 2005: “First, to the extent practical, the FOMC strives to be consistent in how it responds to particular configurations of economic conditions and transparent in explaining the reasons for its response. By building a consistent track record, the FOMC increases its own predictability as well as public confidence in its policies… Lucas 11/2/2020 33
Background – Influenced by – Contributions – Impact – Critique – Questions Impact on Monetary policy • Lucas 11/2/2020 34
Background – Influenced by – Contributions – Impact – Critique – Questions Impact on Economic Research Lucas critique revolutionized the macroeconomic research methodology – from estimating largescale macroeconometric models to models with microfoundations. Lucas 11/2/2020 35
Background – Influenced by – Contributions – Impact – Critique – Questions Wrong Prediction? “the central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades. ” Lucas, 2003, in presidential address to the American Economic Association. Lucas 11/2/2020 36
Background – Influenced by – Contributions – Impact – Critique – Questions 1. Rational expectations theory implies that people always make correct forecasts. True or False? 2. Rational expectations implies that all agents have the same information. True of False? Lucas 11/2/2020 37
Background – Influenced by – Contributions – Impact – Critique – Questions • Lucas 11/2/2020 38
Main Publications Lucas, Robert E. "Expectations and the Neutrality of Money. " Journal of economic theory 4, no. 2 (1972): 103 -124. Lucas, Robert E. "Econometric policy evaluation: A critique. " In Carnegie-Rochester conference series on public policy, vol. 1, pp. 19 -46. North. Holland, 1976. Lucas 11/2/2020 39
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