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1. Learning Outcomes

After studying this module, you shall be able to

Know the Phillips curve relation.

Understand the implications of rational expectations.
Identify the sources of business cycle and employment fluctuations.
Evaluate the Lucas supply curve.
Analyze the implications of rational expectations and Lucas supply curve in the
policy ineffectiveness proposition.

2. Introduction

The development of macroeconomic theory in 1970s was significantly influenced by the

Lucas critique. This critique implies that we cannot use macroeconomic models for
econometric modeling because their in-built assumptions do not serve to check the effects
of alternative policies. This is due to the fact that every macroeconomic model is
endowed with micro foundations. It means justifying assumed behavioural relations
between macroeconomic variables in terms of microeconomic behavior. Lucas developed
his imperfect information model as an alternative theory of the Phillips curve and the
money-driven business cycle, under the assumption of rational expectations. He showed
that a positive relationship between output and inflation could arise because of imperfect
information regarding the aggregate price level. Lucas supply curve has played a
significant role in the formulation of macroeconomic models under rational expectations.
The policy ineffectiveness proposition, that any systematic monetary policy will have no
impact on the time path of aggregate output is based not only upon the assumptions of
rational expectations and market clearing prices, but also upon the assumption that we
incorporate Lucas supply curve.
Let us now discuss in detail the robustness of theoretical propositions associated with
rational expectations and issues relating to neutrality of money, the informational
structure of the economy and the existence of nominal contracts.

3. Link between Inflation and Unemployment

According to Phillips curve, there is a trade-off between inflation and unemployment.
Higher inflation would be accompanied by low unemployment rate. When
unemployment rate is low it becomes difficult for firms to find workers. Whatever supply
of labour is available it comes at high wage which is in turn reflected in high prices. In
such a tight labour market, a union strike would be devastating because firms would be

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unable to recruit additional labour and loose sales. Under such circumstances, firm would
accept higher wage inflation and correspondingly prices will also rise. According to
Phelps and Friedman, in the long run there is no trade-off between inflation and
unemployment as unemployment is at its natural rate. So, they asserted that a permanent
trade-off between inflation and unemployment is illusion. According to Friedman, there
is a short run trade-off between the two as expectation of inflation is slow to adjust. But
he argues that people cannot be fooled forever, so long run trade-off does not exist.
If the monetary authority wants to keep the unemployment rate below the natural rate,
then it should be ready to accept continuously rising inflation which would be beyond

of higher permanent inflation. Adaptive expectations adapt gradually to the changes in

economic variables, so under adaptive expectations policymakers would make some
temporary gain in employment at the cost of higher inflation rate. But when people have
rational expectations, they make use of all the given information and then make a forecast
about inflation rate. The available information includes any proposed monetary or fiscal
policy changes, so expectation error does not have any systematic pattern and forecasting
error turns out to be a random term. Movement of unemployment rate from natural rate
would occur only when error is made but this error is random. This has crucial
implications for monetary policy. It implies that an unanticipated change in money
supply can make actual inflation rate different from expected inflation rate. This is
because any anticipated change in money supply will be taken into account by the people
forming expectations. So, systematic and anticipated monetary policy has no effect on
output and unemployment. It is only unanticipated part which causes expectation error
leading to change in output.

4. Sources of Business Cycle Fluctuations

Business cycles and fluctuations in unemployment have been analysed by Lucas
assuming that the competitive agents are individual representative producers producing
single good and who make decisions on the basis of less than perfect information. The
selling price of this agent is identified with the real wage i.e. on the basis of selling price
the individual will decide how much labour to supply. Whenever there is an increase in
selling price, the corresponding decision to supply more or less labour depends on
whether the increase in selling price is temporary or permanent. If the change is
permanent, then labour supply will not change much. This is because for the primary
worker elasticity of labour with respect to real wage is very low. If the increase in selling
price is temporary then he makes the substitution between labour and leisure. This
happens because leisure has become an expensive commodity now. So, small fluctuations
in real wage will cause large fluctuations in employment. On the other hand, for
permanent change in selling price, the employment will not change much. According to
Lucas, the workers are always on the labour supply curve where labour market always
clears. He does not believe in involuntary unemployment. There are fiscal policy effects
also on the labour supply like changes in the tax rate which affect the after tax income of
the individual but here also permanent change in tax rate will have small effect on labour
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supply. To decide whether the change in price is temporary or permanent, the individual
has to make expectation about it. This expectation would rely on past experience of the
individuals. If in the past period most of the change in prices is permanent, then he would
expect the price change to be permanent and labour supply will not change. If the price
change is temporary in the past period, he would expect the current price change to be
temporary.

Also, the change in taste or invention of new products or technology might produce profit
for some and losses for others. So, some individuals would face an increase in price while
others a decrease in price. Those who face increase in price will vary their labour supply
depending upon how much the change is temporary.

Another source of business cycle is uncertainty in the nominal prices. The individuals are
interested in purchasing power of one unit of labour and not just the nominal payment. If
aggregate price is uncertain then individual has to decide whether the change in price is
change in real price or not. If all the prices increase then there might not be a change in
relative supply price but if other prices do not change then there would be change in his
relative price. So, the individual has to rely on past experience for the price change. Here,
we assume that individual does not have too much information, so he cannot distinguish
between overall price change and change in relative price.

Lucas argues that gathering information involves time and money as it is difficult to get
information in short notice and sometimes the producer has to respond quickly and it is
not worth waiting to get all the information.

Aggregate and relative price changes cause economy wide business fluctuations.
Fluctuations in business can occur if there is unexpected increase in money supply. This
will lead to unexpected increase in the price level. The individual producer based on past
experience will attribute a part of price change to aggregate price change and a part to the
relative price change. Temporary employment will increase in countries that have volatile
aggregate price level. Producer will view most price movements as aggregate price
changes. So monetary shocks will not cause large fluctuation in GDP and employment.
Whereas in countries with stable price level, unanticipated changes in prices are changes
in relative price and accordingly treated as temporary change will change the
employment and GDP. So in countries with volatile inflation history, workers cannot be
fooled easily and employment will not fluctuate whereas in in stable inflation economies,
policymakers can cause booms easily by changing the unanticipated inflation. But this
policy cannot continue for so long as it would cause inflation rate to be volatile. The
movement in general price level is caused by movement in money but Lucas argues that
long term movement in money and price is strong, but in short period the link is not so
strong. If the link between money and price is close, then agents can easily calculate the
general price level and there would be not be unanticipated inflation and no business
cycle. Another source of business cycle is change in rate of interest. If interest of rate is

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high, agents will work more and put their extra proceeds in bank to enjoy higher
consumption in future.

5. Lucas Supply Curve

The Lucas aggregate supply function which is based on the Lucas imperfect information
model, is a representation of aggregate supply based on the work of new
classical economist Robert Lucas. The model states that economic output is a function of
money or price "surprise." The model accounts for the empirically based trade-off
between output and prices represented by the Phillips curve, but the function breaks from
the Phillips curve since only unanticipated price level changes lead to changes in output.
The model considers the empirically observed short-run correlations between output and
prices, but maintains the neutrality of money in the long-run. The Lucas supply function
with rational expectations under the policy ineffectiveness proposition implies that only
unanticipated changes in the money supply can affect real output. Anticipated changes in
the money supply affect only the price level leaving the real output equal to potential
output.
This implies that since people with rational expectations cannot be systematically
surprised by monetary policy, monetary policy cannot be used to systematically influence
the economy.

The rationale behind Lucas's supply theory is based on how suppliers get information.
Lucas claimed that suppliers had to respond to a "signal extraction" problem when
making decisions based on prices; the firms had to determine what portion of price
changes in their respective industries reflected inflation (nominal change in prices) and
what portion reflected a change in real prices for inputs and outputs. Lucas hypothesized
that suppliers know their own industries better than the general economy. Given this
imbalance in information, a supplier could distinguish a general increase in prices due to
inflation as an increase the relative price for its output, reflecting a better, real price for its
output and encouraging more production. The surprise leads to an increase in production
and employment throughout the economy.
The simple aggregate supply function can be represented simply as:
Y = f (P Pe)
This means that output is a function of gap in actual and expected price level. The Lucas
supply curve adds expectations to this model. Aggregate supply is a function of the and
the potential output and the difference between actual prices (Pt) and the expected price
level based on prices in previous period times a coefficient based on an economy's
sensitivity to price surprises ( ):
e
Yt = Yp t t-1 Pt )

This "Lucas supply curve" models output as a function of the "price" or "money
surprise," the difference between expected and actual inflation. Lucas's "surprise"
business cycle theory fell out of favour after the 1970s when empirical evidence failed to
support this model.
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6. Policy Ineffectiveness Proposition with Lucas Supply Curve

Policy ineffectiveness proposition is related to the ineffectiveness of monetary policy.

Policy ineffectiveness means any predictable change in money has no effect on GDP,
employment or any other real variable. It is only the unpredictable part of money supply
that affects GDP and employment. Changes in money supply whether predictable or
unpredictable will affect the price level and inflation rate but output can be affected by
only unpredictable or unanticipated movement in money supply. Sargent and Wallace
have worked on the policy ineffectiveness proposition using the following relations:

1.) Aggregate Demand Relation (based on quantity theory of money)

According to quantity theory,
MV = PY
Taking logs, we get
M t + Vt = P t + Yt
Where Mt = log of money supply
Vt = log of constant velocity of money
Pt = log of price level
Yt = log of real output
According to this equation, the demand for money is not function of rate of interest i.e. it
does not respond to changes in r.

2.) Lucas Supply Curve

e
Yt = Yp t t-1 Pt )
Where Yt = actual output
Yp = potential or full employment output
Pt = actual level of prices
e
t-1Pt = log of price that people expect will occur in period t based on prices in period t-1

According to this aggregate supply curve, the difference between actual and full
employment output depends on the difference between the actual and the expected price.
If Pt > t-1Pte then Yt > Yp and if Pt < t-1Pte then Yt < Yp

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Fig1. Lucas Supply Curve

In Fig 1 aggregate demand curve is drawn for a given money supply, it is downward
sloping because higher prices will lead to lower output to keep the nominal demand
constant. Aggregate supply curve is drawn for a given expected price level, it is upward
sloping implying that at higher price level the gap between actual and expected prices rise
and thus leads to more output being produced. At the intersection of these two curves
equilibrium price and output level is determined. If the price expectations are fixed, then
a monetary expansion by the monetary authorities will shift the AD curve rightwards
leading to a rise in prices as well as output. Thus, only AD shifts while the AS remains at
its original level as shown in Fig 2. This result is incompatible if we incorporate the
rational expectations in our model. For this we introduce the money supply rule.

Fig 2 Shift in Aggregate Demand

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3.) Money Supply Rule

Mt Yt-1 t
Yt-1 = la
t = unpredictable shock (random error term)

a random error term. This error term has zero expected value and it cannot be predicted
either by monetary authorities or public. Yt-1 is the feedback policy of the authorities as it
depends on the past value of the observed variable.

authorities has no impact on output o t

which would affect the output and employment in the economy.

In our previous analysis of monetary expansion, an anticipated shift in money supply

shifts AD to the right but due to rational expectations, p
also revise upward. As a result, AS curve also shifts upwards so that the level of output
remains at full employment and monetary expansion causes only price change as shown
in Fig 3. But this result is compatible only if there is no random shock in the economy.
Under Rational expectations,
e
t-1Pt = E [Pt/I t-1]

where E [Pt/I t-1] = 0

Fig 3: Ineffectiveness of Monetary Policy

Thus using the following relations we derive the implications of policy ineffectiveness
proposition.

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Aggregate demand: Mt + Vt = Pt + Yt

Lucas supply curve: Yt = Yp t t-1 Pte)

Money supply rule: Mt Yt-1 t

Rational Expectations: t-1 Pte = E [Pt/I t-1]

Substituting Lucas supply curve equation in AD curve:

M t + Vt - P t = Yp Pt t-1 Pte)

Taking mathematical expectation on both sides,

Yt-1 + Vt - t-1 Pte = Yp

e
t-1Pt Yt-1 + Vt - Yp

The expected money is calculated by using the money supply rule that:
t] = 0
2.) E [Pt/I t-1] = t-1 Pte
3.) E [Pt-1 - t-1 Pte] = 0 i.e. forecasting error is zero.

Substituting the money supply rule and equation in:

M t + Vt - P t = Yp t t-1 Pte)

We get,
t-1 t + Vt - P t = Yp t - Yt-1 - Vt + Yp)
Solving the above we get,

Pt t-1 + Vt - Yp t

t-1 + Vt - Yt = t-1 Pte

Pt = t-1 Pte t

Pt - t-1 Pte t

Using Lucas supply curve,

Yt = Yp t

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This equation reflects the policy ineffectiveness proposition that only the unanticipated
t, can affect output. The predictable part of money supply will
only affect prices and not output. This implies neutrality of money which says that
anticipated change in money stock affect only nominal variables and not the real
variables. Also, According to Lucas supply equation, output deviates from the full
employment level only when prices deviate from expected prices.

7. Summary
1. The trade between inflation and unemployment disappears in the long run when people
are assumed to have rational expectations.
2. There are many sources of business cycles that have been listed by Lucas including
imperfect information, uncertainty in nominal prices, changes in technology, changes in
rate of interest etc.
3. The Lucas aggregate supply function is based on the Lucas imperfect information
model which states that economic output is a function of money or price "surprise
4. Policy ineffectiveness proposition is related to the ineffectiveness of monetary policy.
The inclusion of Lucas supply curve and rational expectations leads to no change in real
variables when the money supply is raised.
5. PIP with Lucas supply curve implies that money is neutral which implies that
anticipated change in money stock affect only nominal variables and not the real
variables.

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Module 27: Lucas Supply Curve