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10 October 1995

The Royal Swedish Academy of Sciences has decided to award the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, 1995, to

Professor Robert E. Lucas, Jr., University of Chicago, USA,

for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy.

Rational Expectations Have Transformed Macroeconomic Analysis and Our Understanding of Economic Policy

Robert Lucas is the economist who has had the greatest influence on macroeconomic research since 1970. His work has brought about a rapid and revolutionary development: Application of the rational expectations hypothesis, emergence of an equilibrium theory of business cycles, insights into the difficulties of using economic policy to control the economy, and possibilities of reliably evaluating economic policy with statistical methods. In addition to his work in macroeconomics, Lucas’s contributions have had a very significant impact on research in several other fields.

Rational Expectations
Expectations about the future are highly important to economic decisions made by households, firms and organizations. One among many examples is wage formation, where expectations about the inflation rate and the demand for labor in the future strongly affect the contracted wage level which, in turn, affects future inflation. Similarly, many other economic variables are to a large extent governed by expectations about future conditions.

Despite the major importance of expectations, economic analysis paid them only perfunctory attention for a long time. Twenty years ago, it was not unusual to assume arbitrarily specified or even static expectations, for example that the expected future price level was regarded as the same as today’s price level. Or else adaptive expectations were assumed, such that the expected future price level was mechanically adjusted to the deviation between today’s price level and the price level expected earlier.

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.

The Phillips Curve Example
The change in our understanding of the so-called Phillips curve is an excellent example of Lucas’s contributions. The Phillips curve displays a positive relation between inflation and employment. In the late 1960s, there was considerable empirical support for the Phillips curve; it was regarded as one of the more stable relations in economics. It was interpreted as an option for government authorities to increase employment by pursuing an expansionary policy which raises inflation. Milton Friedman and Edmund Phelps criticized this interpretation and claimed that the expectations of the general public would adjust to higher inflation and preclude a lasting increase in employment: Only the short-run Phillips curve is sloping, whereas the long-run curve is vertical. This criticism was not quite convincing, however, because Friedman and Phelps assumed adaptive expectations. Such expectations do in fact imply a permanent rise in employment if inflation is allowed to increase over time. In a study published in 1972, 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, stabilization 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 endeavor, 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 stabilization 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.

The short-run sloping and long-run vertical Phillips curve illustrates the pitfalls of uncritically relying on statistically estimated so-called macroeconometric models to draw conclusions about the effects of changes in economic policy. In a 1976 study, introducing what is now known as the “Lucas critique”, Lucas demonstrated that relations which had so far been regarded as “structural” in econometric analysis were in fact influenced by past policy. Two decades ago, virtually all macroeconometric models contained relations which, on closer examination, could be shown to depend on the fiscal and monetary policy carried out during the estimation period. Obviously, then, the same relations cannot be used in simulations designed to predict the effect of another fiscal or monetary policy. Yet this was exactly how the models were often used.

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 – for example, 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 behavior of economic agents due to revised expectations.

How could researchers avoid the mistakes forewarned by the Lucas critique? Lucas’s own research provided the answer by calling for a new research program. The objective of the program was to formulate macroeconometric models such that their relations are not sensitive to policy changes; otherwise, the models cannot contribute to a reliable assessment of economic-policy alternatives. It is easy to formulate this principle: the models should be “equilibrium models” with rational expectations. This means that all important variables 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. In addition, the models should be formulated so that they only incorporate policy-independent parameters (those coefficients which describe the relations of the models). This, in turn, requires sound microeconomic foundations, i.e., the individual agents’ decision problems have to be completely accounted for in the model. The parameters are then estimated using econometric methods developed for this purpose. Interesting attempts to derive and estimate such models have subsequently been made in several different areas, such as the empirical analysis of investment, consumption and employment, as well as of asset pricing on financial markets. The program can be difficult to implement in practice however, and not all attempts have been successful.

A Large Following
Lucas formulated powerful and operational methods for drawing conclusions from models with rational expectations. These methods provided the means for rapid development of macroeconomic analysis and eventually became part of the standard toolbox. Without them, the outcome of the rational expectations hypothesis would have been limited to general insights into the importance of expectations instead of clear-cut statements in specific situations. Rational expectations have now been accepted as the natural basis for further studies of expectation formation with respect to limited rationality, limited computational capacity and gradual learning.

Lucas has established new areas of research. After his pioneering work on the Phillips curve, the so-called equilibrium theory of business cycles has become an extensive and dynamic field, where the effects of real and monetary disturbances on the business cycle have been carefully examined. The equilibrium theory of business cycles initially relied on the assumption of completely flexible prices and immediate adjustment to equilibrium on goods and labor markets with perfect competition. However, Lucas’s methodological approach is not incompatible with sticky prices and various market failures such as imperfect competition and imperfect information. Nevertheless, these frictions and imperfections should not be introduced in an arbitrary way, but should be explained as a result of rational agents’ decisions and interaction in a well-specified choice situation. Interpreted in this way, Lucas’s methodological approach has been accepted by nearly all macroeconomists. Indeed, the greatest advances in modeling frictions and market imperfections seem to have been made precisely when this methodological approach has been followed.

Lucas’s pioneering work has created an entirely new field of econometrics, known as rational expectations econometrics. There, the rational expectations hypothesis is used to identify the most efficient statistical methods for estimating economic relations where expectations are the key components. A number of researchers have subsequently made important contributions to this new field.

Other Contributions
In addition to his work in macroeconomics, Lucas has made outstanding contributions to investment theory, financial economics, monetary theory, dynamic public economics, international finance and, most recently, the theory of economic growth. In each of these fields, Lucas’s studies have had a significant impact; they have launched new ideas and generated an extensive new literature.

Further reading

The Royal Swedish Academy of Sciences (1995), The Scientific Contributions of Robert E. Lucas, Jr.

Lucas, R.E. (1972), “Expectations and the Neutrality of Money”, Journal of Economic Theory 4, 103-124.

Lucas, R.E. (1976), “Econometric Policy Evaluation: A Critique”, Carnegie-Rochester Conference Series on Public Policy 1, 19-46.

Lucas, R.E. (1981), Studies in Business-Cycle Theory, MITPress, Cambridge, MA.

Lucas, R.E. (1987), Models of Business Cycles, 1985, Yrjö Jahnsson Lectures, Basil Blackwell, Oxford.

Lucas’s achievements are described at greater length in Royal Swedish Academy of Sciences (1995). His two best-known publications are Lucas (1972) and (1976). The research he carried out during the 1970s is compiled in Lucas (1981). A relatively easily accessible account of his views on business-cycle theory may be found in Lucas (1987).

Robert E. Lucas, Jr. was born in 1937 in Yakima, Washington, USA. He received his Ph.D. in economics from the University of Chicago in 1964. He began as Assistant Professor of Economics in 1963 at Carnegie-Mellon University, where he became Associate Professor in 1967 and Professor of Economics in 1970. Since 1975, he has held a professorship in Economics at the University of Chicago. He is Second Vice-President of the Econometric Society, a Fellow of the American Academy of Arts and Sciences and a member of the National Academy of Sciences.

Professor Robert E. Lucas, Jr.
Department of Economics
University of Chicago
1126 East 59th Street
Chicago, IL 60637
USA

The Scientific Contributions of Robert E. Lucas, Jr.