Academic journal article Journal of Economics and Economic Education Research

Lucas Island Model: A "Case Study" for Improving Students' Skill in Interpreting Macroeconomic Models

Academic journal article Journal of Economics and Economic Education Research

Lucas Island Model: A "Case Study" for Improving Students' Skill in Interpreting Macroeconomic Models

Article excerpt

INTRODUCTION

The failure of mainstream researchers to predict the 2007-2008 economic crisis has prompted a group of economists to require some deep changes within the economic profession in several directions. For instance, Colander (2009, 2010) proposes three main changes. First, he requires that macroeconomic models with significant policy relevance should include warning labels directed to non-scientific users of the model. Second, he asks for a wider range of peers in the funding peer review process so as to encourage more creative research on a much wider range of models. Finally, he recognizes that most economists and policymakers have scarce ability to choose an appropriate model, or relate a model to policy, with obvious bad implications for the implementation of economic policy especially when facing deep economic crises. In order to overcome this shortcoming, Colander (2010) maintains that a growing number of researchers should be trained in interpreting models rather than developing them.

Following this last proposal, in this paper we use Lucas's 1972 model as a kind of theoretical "case study" in order to improve students' ability to interpret modern macroeconomics models. While this model is commonly regarded as a mile stone in modern macroeconomics and still widely taught, in the literature there is also a growing emphasis on its limitations as an account of business cycles (see e.g., Zarnowitz 1992, Romer 2005). For this reason, we believe it is now time to address Lucass model in a more critical manner also at the classroom level.

One way to do this is to go beyond both most textbooks' simplified presentations and naive classroom "parables" which paradoxically do not take account of the most distinctive methodological feature of the modern macroeconomic theory, i.e., the complete microfoundation of agents' behaviour functions. Ever since Lucas's original articles many important contributions have sought to remedy this flaw (see e.g., Azariadis 1981, Benassy 1999, Bull and Friedman 1983), but turn out difficult to teach. Indeed a gap still exists between these relatively advanced contributions and classroom presentations.

This aim of this paper is to fill this gap by developing a teaching apparatus of Lucas's original model aimed at improving undergraduates understanding of the underlying structures of mainstream macroeconomic models.

Our teaching apparatus presents three distinctive features. First, it shows how the imperfect information problem arises by assuming from the start that the household consists of two individuals, a " producer " and a " shopper " in a two-island context. As noted for example by Romer (2005), this assumption represents an alternative way with respect to Lucas's original overlapping generation structure to account for imperfect information since it makes possible the lack of communication between the two individuals and thus the confusion between relative and absolute prices changes needed for deriving the positively sloped aggregate supply. Second, in order to capture the close contiguity of Lucas's model with the traditional classical pre-Keynesian approach and, consequently, appreciate its most significant contribution to economic theory, our apparatus starts by focusing on the working of Lucass model in the absence of imperfect information so to define a starting benchmark of the analysis. Third, instead of a shortcut approach to modeling aggregate demand such as Romer's, we add a money market. While it is true, as Romer says in his textbook, that there is little point in modeling aggregate demand more fully in view of the key focus of Lucas's approach on aggregate supply, yet we believe that this novelty adds pedagogical value to the presentation as it allows students to think in terms of a more familiar aggregate demand and supply structure.

The paper is organized as follows. Section 2 presents the basic model and analyzes the role of money in the perfect information context. …

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