1Economics 202A Lecture III Fall 2007The problem set on Lucas and Sargent will be due next Tuesday.In addition you will owe me your second log.We are going to do two things in this class.1. I will go over the reading list, with a bit of emphasis on the first readings onrational expectations. 2. Then I will go over the first real economics article on the reading list. I am now going to go over the reading list, which I have not done so far because Ithought it was more important last week that we get a start on substantivematerial.So let’s go over the reading list. If you have one with you please use that.I have made a copy of one reading list for every two people, so I will pass out newcopies, but I want you to share. Let me now go over the reading list. [Hand out copies.]This will also serve as the introduction to today’s lecture.We have just covered the first section of the reading list.In the first lecture I gave a review of the basic Keynesian model.Then I reviewed math background that you should know in the second lecture.and then I gave a review of a basic Keynesian model.We have also covered the mathematical background to the course, which isdifference equations and ARMA processes.By now you should have done the reading on Time Series Processes. If you havenot done so this is a reminder to make you feel guilty.You should also have read David Romer’s Chapter 5, which is a review ofmacroeconomics. If you have not done that you should be sure to do that.This takes us to section II of the Reading List–on equilibrium concepts.Robert Lucas and Tom Sargent posed a very interesting problem for economics in2the 1970's.They showed that if people have rational expectations and if labor markets arebasically clearing, then monetary policies that react to unemployment or inflationare no more stabilizing than monetary policies that are purely neutral.The only important part of monetary policy is the unexpected part. Any systematicpart of monetary policy has no effect–simply because people take it into accountand their actions will counteract it.Let’s look at a very simple view of their proposition.Suppose that you and I are playing a game, and you get a reward that is reducedby the deviation between the number you name and the number that I name.Then it does not matter what rule I have for generating my number since you willsimply copy it.Suppose that I name the numberf(t) + vwhere v is the zero-mean random partand f(t) is the systematic part.Suppose you know the rule f(t). You can learn the systematic part of my rule.Then your best rule is to name f(t).And the deviation from exact matching of the numbers is v.It does not matter what my choice of f(t) is.With any f(t) you will do equally well, or equally badly.In sum I do not affect you by my choice of the systematic part of my number–onlyby the random part v, which is unexpected.This is the exact picture given by Lucas and Sargent regarding monetary policy.It explains why monetary policy cannot stabilize output and employment over thelong run.We will review this interesting proposition in much more detail.3This matching proposition is absolutely central to Chicago economics.The Chicago view is that if the monetary authority names f(t), of course you willalso name f(t).They obtain thereby a neutrality result. That neutrality result is that the systematic part of the monetary policy has noeffect on income and renders monetary policy ineffective.This is one of at least five neutrality results that come from the University ofChicago.They occur with different reasons. These neutrality results suggest that the Keynesian models, like the one that Ipictured make no sense.Once one takes into account the rationality and intentionality of decisions you willsee that private decisions will simply offset any systematic effects of monetarypolicy. This is contrary to the model that I put on the board in the first class.That Keynesian model implicitly was viewing people as acting like machines. These machines mainly base their decisions on present oriented variables.Especially, they make decisions about current consumption dependent on theircurrent income.Investors also base their decisions on current investment dependent on currentprofits which are also largely dependent on current income.The decisions in such an economy are made based on some rule of thumb, ratherthan being tremendously well thought out.In contrast Lucas and Sargent believe that people are much more thoughtful abouttheir decisions.In their model there is only one well-defined game that is being played.That is the game that I just described where the monetary authority names f(t)and the public responds to minimize the gap between f(t) + v and f(t).I think that it is good economics to see that this is the game that is being played inthe classical economy.But I think that is appallingly bad economics to think that people actually seethrough to perceive that this is the game and follow exactly the strategy thateveryone at the University of Chicago says that they will follow.4I am now going to give you a cryptic note that I hope will become clearer by theend of the course.There is another objection which I also think is basic.That objection is that the different f(t)’s may not be neutral to how the people thinkthey should respond.The f(t)’s are only neutral in a very special case.That special case is the case where people think exactly like economists, so theyhave no money illusion.But if people have even some small amount of money illusion they will act as if thedifferent f(t)’s correspond to different games. This system only works if all the agents in the economy think exactly like aneconomist. But if they behave otherwise, or even if they only think that others willbehave otherwise, then the system is not going to work this way.I know that is now cryptic, but hopefully by the end of the course you will see whatit means.To continue down the reading list, we next go over the Taylor model.The Taylor model explains why monetary-neutrality will not hold if there are somenominal rigidities. The Taylor model is a simple model with a small amount ofnominal wage rigidity. I then put in Shiller, Kahneman, Knetsch and Thaler, and Shafir, Diamond andTversky.Lucas and Sargent wrote very beautiful articles making the type of assumptionthat one might make if one were thinking about the economy in an abstractway–perhaps in a class room with no windows.They assume