Economics 314 Coursebook, 2009 Jeffrey Parker 10 AGGREGATE SUPPLY WITH IMPERFECT INFORMATION Chapter 10 Contents A. Topics and Tools ............................................................................ 1 B. The Lucas Model in Historical Perspe c ti ve ............................................ 2 Keynesian macroeconomics in the 1960s ......................................................................... 2 Monetarism ................................................................................................................. 3 The analytical framework of the Keynesian/monetarist debate ......................................... 4 Rational expectations .................................................................................................... 5 Policy ineffectiveness ..................................................................................................... 6 Lucas and macroeconomic modeling .............................................................................. 7 C. Understanding Romer’s Chapter 6, Part A ............................................ 8 The basic idea .............................................................................................................. 8 Modeling considerations ................................................................................................ 9 Romer’s formalization of the Lucas model ..................................................................... 10 The signal-extraction problem ...................................................................................... 12 Policy ineffectiveness ................................................................................................... 14 D. Aggregate Supply and Demand and the Lucas Model .............................. 15 E. Suggestions for Further Reading ........................................................ 17 Collections of research papers on rational expectations and Lucas model .......................... 17 Surveys of the main results of rational expectations models ............................................. 18 F. Works Cited in Text ....................................................................... 18 A. Topics and Tools This is one of the longer and more challenging sections of the course. Romer’s Chapter 6 is divided into three main sections: Part A covering the Lucas model with imperfect information, Part B looking at models of coordination failures, and Part C discussing sticky-price models. We begin with Robert Lucas’s imperfect information model, which sits at a ma-jor crossroads in the evolution of macroeconomic theory. The Lucas model10 – 2 represents macroeconomists’ first voyage into mathematical modeling of a complete monetary-macroeconomic system based on well-specified microeconomic assump-tions. It was also the first application of the concept of rational expectations in ma-croeconomics. Despite its historical importance, the more extreme implications of the Lucas model have failed to survive the intense battery of empirical testing to which they have been subjected. Few economists still believe that anticipated changes in the money supply are completely neutral or that prices adjust instantly to clear goods and labor markets. Nonetheless, the dynamic microfoundations approach to model-ing the macroeconomy remains Lucas’s legacy to the profession and dominates the way that modern macroeconomists do their work. Lucas was awarded the Nobel Prize in economics in 1995. Romer’s analysis of the Lucas model begins in Section 6.1 with a purely classical model in which markets are perfectly competitive. As expected, the aggregate-supply curve in this model is perfectly inelastic and changes in money (aggregate demand) have no effect on real variables. A true Lucas model is introduced in Section 6.2 with the introduction of imperfect information into the previous classical model. B. The Lucas Model in Historical Perspective To understand the significance of the development of the neoclassical imperfect information model, it is helpful to have some understanding of the state of macroeco-nomics as of 1970, when Lucas began publishing his path-breaking work. At that time, there were basically two schools of macroeconomic thought, the Keynesians and the monetarists. The intellectual battlefield on which they did combat was large-ly a Keynesian one: short-run analysis with a heavy emphasis on using monetary and fiscal policy for business-cycle stabilization. Keynesian macroeconomics in the 1960s The majority of the macroeconomics profession in the 1940s through the 1960s lined up as Keynesians. Their basic framework of analysis was the IS/LM model with a Phillips curve grafted on to predict inflation. Monetary neutrality was dis-missed by this group as applying only to idealized models based on unrealistic class-room assumptions. The Keynesians were confident that money had real effects in the “real world.” In terms of policy analysis, Keynesians of this period relied on the ob-served empirical regularity of the traditional Phillips curve to justify the existence of a tradeoff between high unemployment and high inflation. Reducing either inflation or unemployment was thought to lead inevitably to an increase in the other.10 – 3 By the 1960s, the research agenda of the Keynesians was to estimate the basic structural functions of the Keynesian model with ever-greater precision. Empirical models of the consumption function, investment function, demand function for money, and Phillips curve formed the core of an ever-expanding set of larger and larger macroeconometric forecasting models. These models, which grew to as many as 3,000 equations and a like number of endogenous variables, were (and still are) used routinely to forecast future movements in the economy and to simulate the effects of government policies. Keynesians generally advocated the active use of monetary and fiscal policy to combat business cycles. As soon as a recession began, the central bank was advised to expand the money supply more rapidly and lower interest rates to increase aggre-gate demand and stimulate the economy. Expansionary fiscal policy would take the form of higher government spending and/or lower taxes. It is worth noting that while traditional Keynesian analysis fell out of favor in the 1970s among academic economists, businesspeople and policymakers still rely on Keynesian-style models to