Academic journal article
By Chari, V. V.
Federal Reserve Bank of Minneapolis Quarterly Review , Vol. 23, No. 2
In the late 1960s and early 1970s, Robert E. Lucas, Jr., wrote a number of papers which have rightly been revered as modem classics. For this body of work, Lucas received the Nobel Prize in Economic Sciences in the fall of 1995. The purpose of this review is to place Lucas' work in a historical context and to evaluate the effect of this work on the economics profession. In writing this review, I have benefited greatly from Lucas' (1996) Nobel lecture and from the essay of Thomas Sargent (1996) which was written to kick off a conference held at the Federal Reserve Bank of Minneapolis to celebrate the 25th anniversary of the publication of Lucas' (1972) seminal paper, "Expectations and the Neutrality of Money."
Lucas' work is sometimes heralded as revolutionary, marking the beginning of the end of Keynesian economics and the birth of rational expectations economics. This tendency to mark all key developments in economics as revolutionary is popular enough, but in my view, it is a misreading of the history of economic thought. My thesis is that Lucas' work is very much a part of the natural progress of economics as a science. Scientific progress arises from the interaction between theory and data and the desire to have one unified theory to account for the observations at hand. The search for such a theory proceeds by developing specific abstractions, or models, to understand specific observations. These abstractions then lead to the development of a more general theory, which in turn leads to discarding models which are inconsistent with data and to the development of better models. Lucas' central contribution was to develop and apply economic theory to specific questions in macroeconomics and to make obsolete one class of models. With trenchant vigor and uncommon grace, Lucas argued that economic theory could be used to illuminate old and puzzling substantive questions.
Lucas' contributions are both methodological and substantive. The methodological contribution is to illustrate how one goes about constructing dynamic, stochastic general equilibrium models to shed light on questions of substantive economic interest. The substantive contribution is to develop and analyze a specific mechanism by which monetary instability leads to fluctuations in output and inflation. It is hard to overemphasize the contribution to method. Economists today routinely analyze systems in which agents operate in complex probabilistic environments in order to understand interactions about which the great theorists of an earlier generation could only speculate. This sea change is due in substantial part to Lucas.
The Theoretical Foundations of Macroeconomics
By the 1960s, the models used in macroeconomics described the aggregate economy as consisting of a system of equations: one equation to describe consumption, one to describe investment, one to describe money demand, and so on. Each of these equations was loosely thought of as arising from a deeper formulation of individual or finn decision making. This approach was attractive because the models were mathematically explicit and the parameters of the equations could be estimated using the powerful econometric procedures that had been developed in the postwar era under the influence of the Cowles Commission. These macroeconometric models were widely used for answering questions such as, How does the conduct of monetary policy affect output, inflation, and unemployment? A growing consensus in economics viewed these models as fitting the behavior of the U.S. economy and as suitable for generating answers to policy questions; for an expression of this confidence, see Franco Modigliani's (1977) presidential address to the American Economic Association. At the same time, the desirability of making specific the relationship between macroeconometric models and microeconomic theory was widely recognized. That is, macroeconomics needed theoretical foundations.
The chief difficulty in developing these foundations was that macroeconomic questions necessarily involve dealing with dynamics and uncertainty. …