From nobelsrv@www.nobel.ki.seTue Oct 10 12:43:57 1995
Date: Tue, 10 Oct 1995 12:33:39 +0100
From: Nobel Foundation WWW Server <nobelsrv@www.nobel.ki.se>

Kungl. Vetenskapsakademien
The Royal Swedish Academy of Sciences

The Royal Swedish Academy of Sciences has decided to award the Bank of Sweden
Prize in Economic Sciences in Memory of Alfred Nobel, 1995, to

Professor Robert E. Lucas, Jr., University of Chicago, USA, for having
developed and applied the hypothesis of rational expectations, and
thereby having transformed macroeconomic analysis and deepened our
understanding of economic policy.

-------------------------------------------------------------------------------

Rational Expectations Have Transformed Macroeconomic Analysis and Our
Understanding of Economic Policy

Robert Lucas is the economist who has had the greatest influence on
macroeconomic research since 1970. His work has brought about a rapid and
revolutionary development: Application of the rational expectations hypothesis,
emergence of an equilibrium theory of business cycles, insights into the
difficulties of using economic policy to control the economy, and possibilities
of reliably evaluating economic policy with statistical methods. In addition to
his work in macroeconomics, Lucass contributions have had a very significant
impact on research in several other fields.

Rational Expectations
Expectations about the future are highly important to economic decisions made
by households, firms and organizations. One among many examples is wage
formation, where expectations about the inflation rate and the demand for labor
in the future strongly affect the contracted wage level which, in turn, affects
future inflation. Similarly, many other economic variables are to a large
extent governed by expectations about future conditions.

Despite the major importance of expectations, economic analysis paid them only
perfunctory attention for a long time. Twenty years ago, it was not unusual to
assume arbitrarily specified or even static expectations, for example that the
expected future price level was regarded as the same as todays price level. Or
else adaptive expectations were assumed, such that the expected future price
level was mechanically adjusted to the deviation between todays price level
and the price level expected earlier.

Instead, rational expectations are genuinely forward-looking. The rational
expectations hypothesis means that agents exploit available information without
making the systematic mistakes implied by earlier theories. Expectations are
formed by constantly updating and reinterpreting this information. Sometimes
the consequences of rational expectations formation are dramatic, as in the
case of economic policy. The first precise formulation of the rational
expectations hypothesis was introduced by John Muth in 1961. But it did not
gain much prominence until the 1970s, when Lucas extended it to models of the
aggregate economy. In a series of path-breaking articles, Lucas demonstrated
the far-reaching consequences of rational expectations formation, particularly
concerning the effects of economic policy and the evaluation of these effects
using econometric methods, that is, statistical methods specifically adapted
for examining economic relationships. Lucas also applied the hypothesis to
several fields other than macroeconomics.

The Phillips Curve Example
The change in our understanding of the so-called Phillips curve is an excellent
example of Lucass contributions. The Phillips curve displays a positive
relation between inflation and employment. In the late 1960s, there was
considerable empirical support for the Phillips curve; it was regarded as one
of the more stable relations in economics. It was interpreted as an option for
government authorities to increase employment by pursuing an expansionary
policy which raises inflation. Milton Friedman and Edmund Phelps criticized
this interpretation and claimed that the expectations of the general public
would adjust to higher inflation and preclude a lasting increase in employment:
Only the short-run Phillips curve is sloping, whereas the long-run curve is
vertical. This criticism was not quite convincing, however, because Friedman
and Phelps assumed adaptive expectations. Such expectations do in fact imply a
permanent rise in employment if inflation is allowed to increase over time. In
a study published in 1972, Lucas used the rational expectations hypothesis to
provide the first theoretically satisfactory explanation for why the Phillips
curve could be sloping in the short run but vertical in the long run. In other
words, regardless of how it is pursued, stabilization policy cannot
systematically affect long-run employment. Lucas formulated an ingenious
theoretical model which generates time series such that inflation and
employment indeed seem to be positively correlated. A statistician who studies
these time series might easily conclude that employment could be increased by
implementing an expansionary economic policy. Nevertheless, Lucas demonstrated
that any endeavor, based on such policy, to exploit the Phillips curve and
permanently increase employment would be futile and only give rise to higher
inflation. This is because agents in the model adjust their expectations and
hence price and wage formation to the new, expected policy. Experience during
the 1970s and 1980s has shown that higher inflation does not appear to bring
about a permanent increase in employment. This insight into the long-run
effects of stabilization policy has become a commonly accepted view; it is now
the foundation for monetary policy in a number of countries in their efforts to
achieve and maintain a low and stable inflation rate.

The short-run sloping and long-run vertical Phillips curve illustrates the
pitfalls of uncritically relying on statistically estimated so-called
macroeconometric models to draw conclusions about the effects of changes in
economic policy. In a 1976 study, introducing what is now known as the Lucas
critique, Lucas demonstrated that relations which had so far been regarded as
structural in econometric analysis were in fact influenced by past policy.
Two decades ago, virtually all macroeconometric models contained relations
which, on closer examination, could be shown to depend on the fiscal and
monetary policy carried out during the estimation period. Obviously then, the
same relations cannot be used in simulations designed to predict the effect of
another fiscal or monetary policy. Yet this was exactly how the models were
often used.

The Lucas critique has had a profound influence on economic-policy
recommendations. Shifts in economic policy often produce a completely different
outcome if the agents adapt their expectations to the new policy stance.
Nowadays, when evaluating the consequences of shifts in economic-policy regimes
- for example, a new exchange rate system, a new monetary policy, a tax reform
or new rules for unemployment benefits - it is more or less self-evident to
consider changes in the behavior of economic agents due to revised
expectations.

How could researchers avoid the mistakes forewarned by the Lucas critique?
Lucass own research provided the answer by calling for a new research program.
The objective of the program was to formulate macroeconometric models such that
their relations are not sensitive to policy changes; otherwise, the models
cannot contribute to a reliable assessment of economic-policy alternatives. It
is easy to formulate this principle: the models should be equilibrium models
with rational expectations. This means that all important variables should be
determined within the model, on the basis of interaction among rational agents
who have rational expectations and operate in a well-specified economic
environment. In addition, the models should be formulated so that they only
incorporate policy-independent parameters (those coefficients which describe
the relations of the models). This, in turn, requires sound microeconomic
foundations, i.e., the individual agents decision problems have to be
completely accounted for in the model. The parameters are then estimated using
econometric methods developed for this purpose. Interesting attempts to derive
and estimate such models have subsequently been made in several different
areas, such as the empirical analysis of investment, consumption and
employment, as well as of asset pricing on financial markets. The program can
be difficult to implement in practice, however, and not all attempts have been
successful.

A Large Following
Lucas formulated powerful and operational methods for drawing conclusions from
models with rational expectations. These methods provided the means for rapid
development of macroeconomic analysis and eventually became part of the
standard toolbox. Without them, the outcome of the rational expectations
hypothesis would have been limited to general insights into the importance of
expectations instead of clear-cut statements in specific situations. Rational
expectations have now been accepted as the natural basis for further studies of
expectation formation with respect to limited rationality, limited
computational capacity and gradual learning.

Lucas has established new areas of research. After his pioneering work on the
Phillips curve, the so-called equilibrium theory of business cycles has become
an extensive and dynamic field, where the effects of real and monetary
disturbances on the business cycle have been carefully examined. The
equilibrium theory of business cycles initially relied on the assumption of
completely flexible prices and immediate adjustment to equilibrium on goods and
labor markets with perfect competition. However, Lucass methodological
approach is not incompatible with sticky prices and various market failures
such as imperfect competition and imperfect information. Nevertheless, these
frictions and imperfections should not be introduced in an arbitrary way, but
should be explained as a result of rational agents decisions and interaction
in a well-specified choice situation. Interpreted in this way, Lucass
methodological approach has been accepted by nearly all macroeconomists.
Indeed, the greatest advances in modeling frictions and market imperfections
seem to have been made precisely when this methodological approach has been
followed.

Lucass pioneering work has created an entirely new field of econometrics,
known as rational expectations econometrics. There, the rational expectations
hypothesis is used to identify the most efficient statistical methods for
estimating economic relations where expectations are the key components. A
number of researchers have subsequently made important contributions to this
new field. Other Contributions In addition to his work in macroeconomics, Lucas
has made outstanding contributions to investment theory, financial economics,
monetary theory, dynamic public economics, international finance and, most
recently, the theory of economic growth. In each of these fields, Lucass
studies have had a significant impact; they have launched new ideas and
generated an extensive new literature.

-------------------------------------------------------------------------------

Further reading
The Royal Swedish Academy of Sciences (1995), The Scientific Contributions of
Robert E. Lucas, Jr.
Lucas, R.E. (1972), "Expectations and the Neutrality of Money", Journal of
Economic Theory 4, 103-124.
Lucas, R.E. (1976), "Econometric Policy Evaluation: A Critique",
Carnegie-Rochester Conference Series on Public Policy 1, 19-46.
Lucas, R.E. (1981), Studies in Business-Cycle Theory, MITPress, Cambridge, MA.
Lucas, R.E. (1987), Models of Business Cycles, 1985 Yrjv Jahnsson Lectures,
Basil Blackwell, Oxford.
Lucass achievements are described at greater length in Royal Swedish Academy
of Sciences (1995). His two best-known publications are Lucas (1972) and
(1976). The research he carried out during the 1970s is compiled in Lucas
(1981). A relatively easily accessible account of his views on business-cycle
theory may be found in Lucas (1987).

-------------------------------------------------------------------------------

Robert E. Lucas, Jr. was born in 1937 in Yakima, Wahington, USA. He received
his Ph.D. in economics from the University of Chicago in 1964. He began as
Assistant Professor of Economics in 1963 at Carnegie-Mellon University, where
he became Associate Professor in 1967 and Professor of Economics in 1970. Since
1975, he has held a professorship in Economics at the University of Chicago. He
is Second Vice-President of the Econometric Society, a Fellow of the American
Academy of Arts and Sciences and a member of the National Academy of Sciences.

Professor Robert E. Lucas, Jr.
Department of Economics
University of Chicago
1126 East 59th Street
Chicago, IL 60637
USA