Equilibrium Business Cycle Theory
Before Keynes’s (1936) General Theory many economists were actively engaged
in business cycle research (see Haberler, 1963). However, one of the
important consequences of the Keynesian revolution was the redirection of
macroeconomic research towards questions relating to the level of output at a
point in time, rather than the dynamic evolution of the economy over time.
Nevertheless, within mainstream macroeconomics, before the 1970s, the main
approach to the analysis of business cycles after 1945 was provided by
Keynesians and monetarists (see Mullineux, 1984). During the 1970s a new
approach to the study of aggregate fluctuations was initiated by Lucas, who
advocated an equilibrium approach to business cycle modelling (Kim, 1988).
Lucas’s equilibrium theory was a significant departure from Keynesian business
cycle analysis where fluctuations of GDP were viewed as disequilibrium
phenomena. Keynesian macroeconomic models are typically characterized
by various rigidities and frictions that inhibit wage and price flexibility.
Consequently, in the short run, markets fail to clear and GDP can depart
significantly from its potential level for extended periods of time. Milton
Friedman also criticized Keynesian models for their downplaying of the
importance of monetary disturbances as a major source of aggregate instability.
The Friedman and Schwartz (1963) study proved to be highly influential
to a whole generation of economists. In particular Friedman and Schwartz
argued that the Great Depression was ‘a tragic testimonial to the importance
of monetary factors’. While Lucas was very much influenced by Friedman’s
monetarist ideas, he preferred to utilize a Walrasian research methodology
rather than build on Friedman’s Marshallian approach when analysing business
cycles (see Hoover, 1984).
The foundations of Lucas’s approach to business cycle modelling can be
found in his seminal Journal of Economic Theory paper (Lucas, 1972a),
where his objective is clearly stated in the opening paragraphs:
This paper provides a simple example of an economy in which equilibrium prices
and quantities exhibit what may be the central feature of the modern business
cycle: a systematic relation between the rate of change of nominal prices (inflation)
and the level of real output. The relationship, essentially a variant of the wellknown
Phillips curve, is derived within a framework from which all forms of
‘money illusion’ are rigorously excluded: all prices are market clearing, all agents
behave optimally in light of their objectives and expectations, and expectations
are formed optimally … In the framework presented, price movement results from
a relative demand shift or a nominal (monetary) one. This hedging behaviour
results in the nonneutrality of money, or broadly speaking a Phillips curve, similar
in nature to that we observe in reality. At the same time, classical results on the
long-run neutrality of money, or independence of real and nominal magnitudes,
continue to hold.
Lucas demonstrated that within this Walrasian framework, monetary changes
have real consequences, but ‘only because agents cannot discriminate perfectly
between monetary and real demand shifts’ so ‘there is no usable
trade-off between inflation and real output’. In Lucas’s 1972 model ‘the
Phillips curve emerges not as an unexplained empirical fact, but as a central
feature of the solution to a general equilibrium system’.
Building on this insight, Lucas proceeded to develop an equilibrium approach
to the analysis of aggregate fluctuations. Lucas (1975) defines business
cycles as the serially correlated movements about trend of real output that
‘are not explainable by movements in the availability of factors of production’.
Associated with fluctuations in GDP are co-movements among different
aggregative time series, such as prices, consumption, business profits, investment,
monetary aggregates, productivity and interest rates (see Abel and
Bernanke, 2001). Such are the regularities that Lucas (1977) declares that
‘with respect to the qualitative behaviour of co-movements among series,
business cycles are all alike’ (the Great Depression being an exception). To
Lucas the ‘recurrent character of business cycles is of central importance’. As
Lucas (1977) explains:
Insofar as business cycles can be viewed as repeated instances of essentially
similar events, it will be reasonable to treat agents as reacting to cyclical changes
as ‘risk’, or to assume their expectations are rational, that they have fairly stable
arrangements for collecting and processing information, and that they utilise this
information in forecasting the future in a stable way, free of systematic and easily
correctable biases.
Building on his path-breaking 1972 and 1973 papers, Lucas (1975, 1977)
provides a ‘new classical’ monetarist explanation of the business cycle as an
equilibrium phenomenon. As Kevin Hoover (1988) observes, ‘to explain the
related movements of macroeconomic aggregates and prices without recourse
to the notion of disequilibrium is the desideratum of new classical research
on the theory of business cycles’. As Lucas (1975) puts it, ‘the central
problem in macroeconomics’ is to find a theoretical framework where monetary
disturbances can cause real output fluctuations which at the same time
does not imply ‘the existence of persistent, recurrent, unexploited profit
opportunities’ such as occur in Keynesian models characterised by price
rigidities and non-rational expectations.
Hayek (1933) had set forth a research agenda where ‘the crucial problem
of Trade Cycle Theory’ was to produce a solution that would allow ‘incorporation
of cyclical phenomena into the system of economic equilibrium theory,
with which they are in apparent contradiction’. By equilibrium theory Hayek
meant that which had been ‘most perfectly expressed by the Lausanne School
of theoretical economics’. While Keynesian economists regarded the quest
for an equilibrium theory of the business cycle as unattainable, it is one of
Lucas’s most notable achievements to demonstrate that it is possible to develop
an equilibrium account of aggregate instability. Although initially Lucas
claimed some affinity, via the notion of equilibrium theorizing, with the work
of Hayek on business cycles, it is now clear that new classical and Austrian
theories of the business cycle are very different. While the Austrian theory
views business cycles as an equilibrating process, in new classical models the
business cycle is viewed as a ‘continuum of equilibrium’ (Kim, 1988; see
also Chapter 9; Lucas, 1977; Hoover, 1984, 1988; Zijp, 1993).
Lucas’s monetary equilibrium business cycle theory (MEBCT) incorporates
Muth’s (1961) rational expectations hypothesis, Friedman’s (1968a)
natural rate hypothesis, and Walrasian general equilibrium methodology.
With continuous market clearing due to complete wage and price flexibility
the fluctuations in the MEBCT are described as competitive equilibria. But
how can monetary disturbances create fluctuations in such a world? In the
stylized classical model where agents have perfect information, changes in
the money supply should be strictly neutral, that is, have no impact on real
variables such as real GDP and employment. However, the leading and procyclical
behaviour of money observed empirically by researchers such as
Friedman and Schwartz (1963), and more recently by Romer and Romer
(1989), suggests that money is non-neutral (ignoring the possibility of
reverse causation). The intellectual challenge facing Lucas was to account
for the non-neutrality of money in a world inhabited by rational profitmaximizing
agents and where all markets continuously clear. His main
innovation was to extend the classical model so as to allow agents to have
‘imperfect information’. As a result Lucas’s MEBCT has come to be popularly
known as the ‘misperceptions theory’, although the idea of instability
being the result of monetary-induced misperceptions is also a major feature
of Friedman’s (1968a) analysis of the Phillips curve. In Lucas’s (1975)
pioneering attempt to build a MEBCT his model is characterized by: prices
and quantities determined in competitive equilibrium; agents with rational
expectations; and imperfect information, ‘not only in the sense that the
future is unknown, but also in the sense that no agent is perfectly informed
as to the current state of the economy’.
The hypothesis that aggregate supply depends upon relative prices is central
to the new classical explanation of fluctuations in output and employment.
In new classical analysis, unanticipated aggregate demand shocks (resulting
mainly from unanticipated changes in the money supply) which affect the
whole economy cause errors in (rationally formed) price expectations and
result in output and employment deviating from their long-run (full information)
equilibrium (natural) levels. These errors are made by both workers and
firms who have incomplete/imperfect information, so that they mistake gen
eral price changes for relative price changes and react by changing the supply
of labour and output, respectively.
In neoclassical microeconomic theory the supply curve of an individual
producer in a competitive market slopes upward, indicating that the supplier
will produce more in response to a rise in price. However, this profit-maximizing
response is a reaction of producers to a rise in their relative price.
Therefore, individual suppliers need to know what is happening to the general
price level in order to make a rational calculation of whether it is
profitable to expand production in response to an increase in the nominal
price of the good they supply. If all prices are rising due to inflation, suppliers
should not increase production in response to a rise in price of their good
because it does not represent a relative (real) price increase. And yet the data
reveal that aggregate output increases as the general price level increases; that
is, the short-run aggregate supply curve slopes upwards in P–Y space. This
must mean that the aggregate response of thousands of individual suppliers to
a rise in the general price level is positive and yet profit-maximizing individuals
should not be reacting in this way. How can that be? Rational agents
should only respond to real variables and their behaviour should be invariant
to nominal variables. The answer provided by Lucas relates to agents (workers,
households, firms) having imperfect information about their relative prices
(Lucas, 1972a). If agents have been used to a world of price stability, they
will tend to interpret an increase in the supply price of the good (or service)
they produce as a relative price increase and produce more in response.
Therefore an unexpected or unanticipated increase in the price level will
surprise agents and they will misinterpret the information they observe with
respect to the rise in price of their good and produce more. Agents have what
Lucas (1977) refers to as a ‘signal extraction problem’, and if all agents make
the same error we will observe an aggregate increase in output correlated
with an increase in the general price level. Since Lucas’s model is ‘monetarist’,
the increase in the general price level is caused by a prior increase in the
money supply and we therefore observe a positive money-to-output correlation,
that is, the non-neutrality of money.
Consider, for example, an economy which is initially in a position where
output and employment are at their natural levels. Suppose an unanticipated
monetary disturbance occurs which leads to an increase in the general price
level, and hence individual prices, in all markets (‘islands’) throughout the
economy. As noted above, firms are assumed to have information only on
prices in the limited number of markets in which they trade. If individual
firms interpret the increase in the price of their goods as an increase in the
relative price of their output, they will react by increasing their output.
Workers are also assumed to have incomplete information. If workers mistakenly
perceive an increase in money wages (relative to their expected value) as
an increase in real wages, they will respond by increasing the supply of
labour (Lucas and Rapping, 1969). In contrast to Friedman’s model (see
Chapter 4), where workers are fooled, Lucas’s model does not rely on any
asymmetry of information between workers and firms. Both firms and workers
are inclined to make expectational errors and respond positively to
misperceived global price increases by increasing the supply of output and
labour, respectively. As a result aggregate output and employment will rise
temporarily above their natural levels. Once agents realize that there has been
no change in relative prices, output and employment return to their long-run
(full information) equilibrium (natural) levels.
The Lucas model emphasizes monetary shocks as the main cause of aggregate
instability and the whole story is based on a confusion on the part of
agents between relative and general price movements (Dore, 1993; Arnold,
2002). In the MEBCT, the supply of output at any given time (Yt) has both a
permanent (secular) component (YNt) and a cyclical component (Yct) as shown
in equation (5.9):
Yt YNt Yct = + (5.9)
The permanent component of GDP reflects the underlying growth of the
economy and follows the trend line given by (5.10):
YNt t = λ + φ (5.10)
The cyclical component is dependent on the price surprise together with the
previous period’s deviation of output from its natural rate, as shown in equation
(5.11):
Yct Pt E Pt t Yt YNt = − − + − − − α[ ( |Ω 1)] β( 1 1 ) (5.11)
The lagged output term in (5.11) is to recognize that deviations in output
from the trend will be more than transitory due to the influence of a variety of
propagation mechanisms, and the coefficient β > 0 determines the speed with
which output returns to its natural rate after a shock. Because the combination
of the rational expectations hypothesis and the surprise supply function
implies that output and employment will fluctuate randomly around their
natural levels, further assumptions are required to explain why during the
business cycle output and employment remain persistently above (upswing)
or below (downswing) their trend values for a succession of time periods.
The observed serially correlated movements in output and employment (that
is, where output and employment levels in any one time period are correlated
with their preceding values) have been explained in the literature in a number
of ways. These explanations (propagation mechanisms) include reference to
lagged output, investment accelerator effects, information lags and the durability
of capital goods, the existence of contracts inhibiting immediate
adjustment and adjustment costs (see Zijp, 1993). For example, in the field of
employment firms face costs both in hiring and in firing labour: costs associated
with interviewing and training new employees, making redundancy
payments and so on. In consequence their optimal response may be to adjust
their employment and output levels gradually over a period of time following
some unanticipated shock.
By combining equations (5.9), (5.10) and (5.11) we get the Lucas aggregate
supply relationship given by equation (5.12):
Yt t Pt E Pt t Yt YNt t = + + − − + − − − + λ φ α[ ( |Ω 1)] β( 1 1 ) ε (5.12)
where εt is a random error process.
Although the actions of agents in Lucas’s model turn out ex post to be nonoptimal,
they are in a rational expectations equilibrium doing the best they
can given the (imperfect or incomplete) information they have acquired. As
Lucas (1973) demonstrated, this implies that monetary disturbances (random
shocks) are likely to have a much bigger impact on real variables in countries
where price stability has been the norm. In countries where agents are used to
inflation, monetary disturbances are unlikely to impact in any significant way
on real variables. Let θ represent the fraction of total individual price variance
due to relative price variation. Thus the larger is θ, the more any
observed variability in prices is attributed by economic agents to a real shock
(that is, a change in relative price) and the less it is attributed to purely
inflationary (nominal) movements of the general price level. We can therefore
modify equation (5.12) and present the Lucas aggregate supply curve in a
form similar to how it appeared in his 1973 paper ‘Some International Evidence
on Output–Inflation Trade-Offs’:
Yt t Pt E Pt t Yt YNt t = + + − − + − − − + λ φ θα[ ( |Ω 1)] β( 1 1 ) ε (5.13)
According to (5.13) an unanticipated monetary disturbance that takes place in
a country where agents are expecting price stability will lead to a significant
real output disturbance. In (5.13) we observe that output (Yt ) has:
1. a permanent component = λ + φt;
2. a component related to the impact of a price surprise = θα[Pt – E(Pt | Ωt–1)];
3. a component related to last period’s deviation of output from permanent
output = β(Yt–1 – YNt–1); and
4. a random component = εt.
Thus, in the Lucas model business cycles are generated by exogenous monetary
demand shocks that transmit imperfect price signals to economic agents
who, in a world of imperfect information, respond to price increases by
increasing supply. The greater is the general price variability (the lower the
variation in price attributed to relative price variation), the lower will be the
cyclical response of output to a monetary disturbance, and vice versa. A
major policy implication of the MEBCT is that a benign monetary policy
would eliminate a large source of aggregate instability. Thus new classical
economists come down on the side of rules in the ‘rules versus discretion’
debate over the conduct of stabilization policy.
We now turn to consider the main policy implications of the new classical
approach to macroeconomics in more detail.
Before Keynes’s (1936) General Theory many economists were actively engaged
in business cycle research (see Haberler, 1963). However, one of the
important consequences of the Keynesian revolution was the redirection of
macroeconomic research towards questions relating to the level of output at a
point in time, rather than the dynamic evolution of the economy over time.
Nevertheless, within mainstream macroeconomics, before the 1970s, the main
approach to the analysis of business cycles after 1945 was provided by
Keynesians and monetarists (see Mullineux, 1984). During the 1970s a new
approach to the study of aggregate fluctuations was initiated by Lucas, who
advocated an equilibrium approach to business cycle modelling (Kim, 1988).
Lucas’s equilibrium theory was a significant departure from Keynesian business
cycle analysis where fluctuations of GDP were viewed as disequilibrium
phenomena. Keynesian macroeconomic models are typically characterized
by various rigidities and frictions that inhibit wage and price flexibility.
Consequently, in the short run, markets fail to clear and GDP can depart
significantly from its potential level for extended periods of time. Milton
Friedman also criticized Keynesian models for their downplaying of the
importance of monetary disturbances as a major source of aggregate instability.
The Friedman and Schwartz (1963) study proved to be highly influential
to a whole generation of economists. In particular Friedman and Schwartz
argued that the Great Depression was ‘a tragic testimonial to the importance
of monetary factors’. While Lucas was very much influenced by Friedman’s
monetarist ideas, he preferred to utilize a Walrasian research methodology
rather than build on Friedman’s Marshallian approach when analysing business
cycles (see Hoover, 1984).
The foundations of Lucas’s approach to business cycle modelling can be
found in his seminal Journal of Economic Theory paper (Lucas, 1972a),
where his objective is clearly stated in the opening paragraphs:
This paper provides a simple example of an economy in which equilibrium prices
and quantities exhibit what may be the central feature of the modern business
cycle: a systematic relation between the rate of change of nominal prices (inflation)
and the level of real output. The relationship, essentially a variant of the wellknown
Phillips curve, is derived within a framework from which all forms of
‘money illusion’ are rigorously excluded: all prices are market clearing, all agents
behave optimally in light of their objectives and expectations, and expectations
are formed optimally … In the framework presented, price movement results from
a relative demand shift or a nominal (monetary) one. This hedging behaviour
results in the nonneutrality of money, or broadly speaking a Phillips curve, similar
in nature to that we observe in reality. At the same time, classical results on the
long-run neutrality of money, or independence of real and nominal magnitudes,
continue to hold.
Lucas demonstrated that within this Walrasian framework, monetary changes
have real consequences, but ‘only because agents cannot discriminate perfectly
between monetary and real demand shifts’ so ‘there is no usable
trade-off between inflation and real output’. In Lucas’s 1972 model ‘the
Phillips curve emerges not as an unexplained empirical fact, but as a central
feature of the solution to a general equilibrium system’.
Building on this insight, Lucas proceeded to develop an equilibrium approach
to the analysis of aggregate fluctuations. Lucas (1975) defines business
cycles as the serially correlated movements about trend of real output that
‘are not explainable by movements in the availability of factors of production’.
Associated with fluctuations in GDP are co-movements among different
aggregative time series, such as prices, consumption, business profits, investment,
monetary aggregates, productivity and interest rates (see Abel and
Bernanke, 2001). Such are the regularities that Lucas (1977) declares that
‘with respect to the qualitative behaviour of co-movements among series,
business cycles are all alike’ (the Great Depression being an exception). To
Lucas the ‘recurrent character of business cycles is of central importance’. As
Lucas (1977) explains:
Insofar as business cycles can be viewed as repeated instances of essentially
similar events, it will be reasonable to treat agents as reacting to cyclical changes
as ‘risk’, or to assume their expectations are rational, that they have fairly stable
arrangements for collecting and processing information, and that they utilise this
information in forecasting the future in a stable way, free of systematic and easily
correctable biases.
Building on his path-breaking 1972 and 1973 papers, Lucas (1975, 1977)
provides a ‘new classical’ monetarist explanation of the business cycle as an
equilibrium phenomenon. As Kevin Hoover (1988) observes, ‘to explain the
related movements of macroeconomic aggregates and prices without recourse
to the notion of disequilibrium is the desideratum of new classical research
on the theory of business cycles’. As Lucas (1975) puts it, ‘the central
problem in macroeconomics’ is to find a theoretical framework where monetary
disturbances can cause real output fluctuations which at the same time
does not imply ‘the existence of persistent, recurrent, unexploited profit
opportunities’ such as occur in Keynesian models characterised by price
rigidities and non-rational expectations.
Hayek (1933) had set forth a research agenda where ‘the crucial problem
of Trade Cycle Theory’ was to produce a solution that would allow ‘incorporation
of cyclical phenomena into the system of economic equilibrium theory,
with which they are in apparent contradiction’. By equilibrium theory Hayek
meant that which had been ‘most perfectly expressed by the Lausanne School
of theoretical economics’. While Keynesian economists regarded the quest
for an equilibrium theory of the business cycle as unattainable, it is one of
Lucas’s most notable achievements to demonstrate that it is possible to develop
an equilibrium account of aggregate instability. Although initially Lucas
claimed some affinity, via the notion of equilibrium theorizing, with the work
of Hayek on business cycles, it is now clear that new classical and Austrian
theories of the business cycle are very different. While the Austrian theory
views business cycles as an equilibrating process, in new classical models the
business cycle is viewed as a ‘continuum of equilibrium’ (Kim, 1988; see
also Chapter 9; Lucas, 1977; Hoover, 1984, 1988; Zijp, 1993).
Lucas’s monetary equilibrium business cycle theory (MEBCT) incorporates
Muth’s (1961) rational expectations hypothesis, Friedman’s (1968a)
natural rate hypothesis, and Walrasian general equilibrium methodology.
With continuous market clearing due to complete wage and price flexibility
the fluctuations in the MEBCT are described as competitive equilibria. But
how can monetary disturbances create fluctuations in such a world? In the
stylized classical model where agents have perfect information, changes in
the money supply should be strictly neutral, that is, have no impact on real
variables such as real GDP and employment. However, the leading and procyclical
behaviour of money observed empirically by researchers such as
Friedman and Schwartz (1963), and more recently by Romer and Romer
(1989), suggests that money is non-neutral (ignoring the possibility of
reverse causation). The intellectual challenge facing Lucas was to account
for the non-neutrality of money in a world inhabited by rational profitmaximizing
agents and where all markets continuously clear. His main
innovation was to extend the classical model so as to allow agents to have
‘imperfect information’. As a result Lucas’s MEBCT has come to be popularly
known as the ‘misperceptions theory’, although the idea of instability
being the result of monetary-induced misperceptions is also a major feature
of Friedman’s (1968a) analysis of the Phillips curve. In Lucas’s (1975)
pioneering attempt to build a MEBCT his model is characterized by: prices
and quantities determined in competitive equilibrium; agents with rational
expectations; and imperfect information, ‘not only in the sense that the
future is unknown, but also in the sense that no agent is perfectly informed
as to the current state of the economy’.
The hypothesis that aggregate supply depends upon relative prices is central
to the new classical explanation of fluctuations in output and employment.
In new classical analysis, unanticipated aggregate demand shocks (resulting
mainly from unanticipated changes in the money supply) which affect the
whole economy cause errors in (rationally formed) price expectations and
result in output and employment deviating from their long-run (full information)
equilibrium (natural) levels. These errors are made by both workers and
firms who have incomplete/imperfect information, so that they mistake gen
eral price changes for relative price changes and react by changing the supply
of labour and output, respectively.
In neoclassical microeconomic theory the supply curve of an individual
producer in a competitive market slopes upward, indicating that the supplier
will produce more in response to a rise in price. However, this profit-maximizing
response is a reaction of producers to a rise in their relative price.
Therefore, individual suppliers need to know what is happening to the general
price level in order to make a rational calculation of whether it is
profitable to expand production in response to an increase in the nominal
price of the good they supply. If all prices are rising due to inflation, suppliers
should not increase production in response to a rise in price of their good
because it does not represent a relative (real) price increase. And yet the data
reveal that aggregate output increases as the general price level increases; that
is, the short-run aggregate supply curve slopes upwards in P–Y space. This
must mean that the aggregate response of thousands of individual suppliers to
a rise in the general price level is positive and yet profit-maximizing individuals
should not be reacting in this way. How can that be? Rational agents
should only respond to real variables and their behaviour should be invariant
to nominal variables. The answer provided by Lucas relates to agents (workers,
households, firms) having imperfect information about their relative prices
(Lucas, 1972a). If agents have been used to a world of price stability, they
will tend to interpret an increase in the supply price of the good (or service)
they produce as a relative price increase and produce more in response.
Therefore an unexpected or unanticipated increase in the price level will
surprise agents and they will misinterpret the information they observe with
respect to the rise in price of their good and produce more. Agents have what
Lucas (1977) refers to as a ‘signal extraction problem’, and if all agents make
the same error we will observe an aggregate increase in output correlated
with an increase in the general price level. Since Lucas’s model is ‘monetarist’,
the increase in the general price level is caused by a prior increase in the
money supply and we therefore observe a positive money-to-output correlation,
that is, the non-neutrality of money.
Consider, for example, an economy which is initially in a position where
output and employment are at their natural levels. Suppose an unanticipated
monetary disturbance occurs which leads to an increase in the general price
level, and hence individual prices, in all markets (‘islands’) throughout the
economy. As noted above, firms are assumed to have information only on
prices in the limited number of markets in which they trade. If individual
firms interpret the increase in the price of their goods as an increase in the
relative price of their output, they will react by increasing their output.
Workers are also assumed to have incomplete information. If workers mistakenly
perceive an increase in money wages (relative to their expected value) as
an increase in real wages, they will respond by increasing the supply of
labour (Lucas and Rapping, 1969). In contrast to Friedman’s model (see
Chapter 4), where workers are fooled, Lucas’s model does not rely on any
asymmetry of information between workers and firms. Both firms and workers
are inclined to make expectational errors and respond positively to
misperceived global price increases by increasing the supply of output and
labour, respectively. As a result aggregate output and employment will rise
temporarily above their natural levels. Once agents realize that there has been
no change in relative prices, output and employment return to their long-run
(full information) equilibrium (natural) levels.
The Lucas model emphasizes monetary shocks as the main cause of aggregate
instability and the whole story is based on a confusion on the part of
agents between relative and general price movements (Dore, 1993; Arnold,
2002). In the MEBCT, the supply of output at any given time (Yt) has both a
permanent (secular) component (YNt) and a cyclical component (Yct) as shown
in equation (5.9):
Yt YNt Yct = + (5.9)
The permanent component of GDP reflects the underlying growth of the
economy and follows the trend line given by (5.10):
YNt t = λ + φ (5.10)
The cyclical component is dependent on the price surprise together with the
previous period’s deviation of output from its natural rate, as shown in equation
(5.11):
Yct Pt E Pt t Yt YNt = − − + − − − α[ ( |Ω 1)] β( 1 1 ) (5.11)
The lagged output term in (5.11) is to recognize that deviations in output
from the trend will be more than transitory due to the influence of a variety of
propagation mechanisms, and the coefficient β > 0 determines the speed with
which output returns to its natural rate after a shock. Because the combination
of the rational expectations hypothesis and the surprise supply function
implies that output and employment will fluctuate randomly around their
natural levels, further assumptions are required to explain why during the
business cycle output and employment remain persistently above (upswing)
or below (downswing) their trend values for a succession of time periods.
The observed serially correlated movements in output and employment (that
is, where output and employment levels in any one time period are correlated
with their preceding values) have been explained in the literature in a number
of ways. These explanations (propagation mechanisms) include reference to
lagged output, investment accelerator effects, information lags and the durability
of capital goods, the existence of contracts inhibiting immediate
adjustment and adjustment costs (see Zijp, 1993). For example, in the field of
employment firms face costs both in hiring and in firing labour: costs associated
with interviewing and training new employees, making redundancy
payments and so on. In consequence their optimal response may be to adjust
their employment and output levels gradually over a period of time following
some unanticipated shock.
By combining equations (5.9), (5.10) and (5.11) we get the Lucas aggregate
supply relationship given by equation (5.12):
Yt t Pt E Pt t Yt YNt t = + + − − + − − − + λ φ α[ ( |Ω 1)] β( 1 1 ) ε (5.12)
where εt is a random error process.
Although the actions of agents in Lucas’s model turn out ex post to be nonoptimal,
they are in a rational expectations equilibrium doing the best they
can given the (imperfect or incomplete) information they have acquired. As
Lucas (1973) demonstrated, this implies that monetary disturbances (random
shocks) are likely to have a much bigger impact on real variables in countries
where price stability has been the norm. In countries where agents are used to
inflation, monetary disturbances are unlikely to impact in any significant way
on real variables. Let θ represent the fraction of total individual price variance
due to relative price variation. Thus the larger is θ, the more any
observed variability in prices is attributed by economic agents to a real shock
(that is, a change in relative price) and the less it is attributed to purely
inflationary (nominal) movements of the general price level. We can therefore
modify equation (5.12) and present the Lucas aggregate supply curve in a
form similar to how it appeared in his 1973 paper ‘Some International Evidence
on Output–Inflation Trade-Offs’:
Yt t Pt E Pt t Yt YNt t = + + − − + − − − + λ φ θα[ ( |Ω 1)] β( 1 1 ) ε (5.13)
According to (5.13) an unanticipated monetary disturbance that takes place in
a country where agents are expecting price stability will lead to a significant
real output disturbance. In (5.13) we observe that output (Yt ) has:
1. a permanent component = λ + φt;
2. a component related to the impact of a price surprise = θα[Pt – E(Pt | Ωt–1)];
3. a component related to last period’s deviation of output from permanent
output = β(Yt–1 – YNt–1); and
4. a random component = εt.
Thus, in the Lucas model business cycles are generated by exogenous monetary
demand shocks that transmit imperfect price signals to economic agents
who, in a world of imperfect information, respond to price increases by
increasing supply. The greater is the general price variability (the lower the
variation in price attributed to relative price variation), the lower will be the
cyclical response of output to a monetary disturbance, and vice versa. A
major policy implication of the MEBCT is that a benign monetary policy
would eliminate a large source of aggregate instability. Thus new classical
economists come down on the side of rules in the ‘rules versus discretion’
debate over the conduct of stabilization policy.
We now turn to consider the main policy implications of the new classical
approach to macroeconomics in more detail.
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