Lucas aggregate supply function: Difference between revisions

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The '''Lucas aggregate supply function''' or '''Lucas 'surprise' supply function''', based on the '''Lucas imperfect information model''', is a representation of [[aggregate supply]] based on the work of [[New classical macroeconomics|new classical]] economist [[Robert Lucas, Jr.|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.<ref>{{cite book |first=Olivier Jean |last=Blanchard |authorlink=Olivier Blanchard |first2=Stanley |last2=Fischer |authorlink2=Stanley Fischer |chapter=The Lucas Model |title=Lectures on Macroeconomics |___location=Cambridge |publisher=MIT Press |year=1989 |isbn=0-262-02283-4 |chapterurl={{Google books |plainurl=yes |id=j_zs7htz9moC |page=358 }} |pages=356–360 [p. 358] }}</ref> The model accounts for empirically observed short-run correlations between output and prices, but maintains the [[neutrality of money]] (the absence of a price or money supply relationship with output and employment) in the long-run. The [[Policy Ineffectiveness Proposition|policy ineffectiveness proposition]] extends the model by arguing that, since people with [[rational expectations]] cannot be systematically surprised by [[monetary policy]], monetary policy cannot be used to systematically influence the economy.

== Background ==

New classical made its first attempt to model aggregate supply in Lucas and [[Leonard Rapping]] (1969).<ref>{{Cite journal | doi = 10.2307/1808963| jstor = 1808963| doi_brokendate = 2015-04-10|title=Price Expectations and the Phillips Curve|author1=Robert E. Lucas, Jr.|author2= Leonard A. Rapping|journal=The American Economic Review|volume=59|number= 3|date=June 1969|pages= 342–350|publisher= American Economic Association}}</ref> In this earlier model, supply (specifically labor supply) is a direct function of real wages: More work will be done when real wages are high and less when they are low. Under this model, unemployment is "voluntary."<ref name="SnowdonVane233">Snowdon and Vane (2005), 233.</ref> In 1972 Lucas made a second attempt at modelling aggregate supply.<ref name="SnowdonVane233" /> This attempt drew from [[Milton Friedman]]'s [[natural rate hypothesis]] that challenged the Phillips curve.<ref name="SnowdonVane453">Snowdon and Vane (2003), 453.</ref> Lucas supported his original, theoretical paper that outlined the surprise based supply curve with an empirical paper that demonstrated that countries with a history of stable price levels exhibit larger effects in response to monetary policy than countries where prices have been volatile.<ref name="SnowdonVane453" />

On the basis of Lucas’ 1973 paper,<ref>{{cite journal|last1=Lucas|first1=Robert|title=Some international evidence on output-inflation tradeoffs|journal=American Economic Review|date=1973|volume=63|issue=3|pages=326–334}}</ref> [[Thomas Sargent]] and [[Neil Wallace]] intruduced their ’surprise’ supply function in which there was a white noise error term introduced that cannot be predicted in any way.<ref>{{cite journal|last1=Sargent|first1=Tom|last2=Wallace|first2=Neil|title=Rational" expectations, the optimal monetary instrument, and the optimal money supply rule|journal=Journal of Political Economy|date=1975|volume=83|issue=2|pages=241–254}}</ref> intruduced their ’surprise’ supply function in which there was a white noise error term introduced that cannot be predicted in any way. Lucas introduced the effects of nominal and real shocks affecting a macro-economy into his system through price expectations: if expectations are true, output in any given period is at its natural level. However, the well-known and widely accepted aggregate production function described by Sargent and Wallace also provides leeway for the white-noise shocks independent of price expectations–resulting in the accidental nature of equilibrium and in the inefficacy of countercyclical efforts of monetary policy.<ref>{{cite book |last=Galbács |first=Peter |title=The Theory of New Classical Macroeconomics. A Positive Critique |___location=Heidelberg/New York/Dordrecht/London |publisher=Springer |year=2015 |isbn= 978-3-319-17578-2 |doi=10.1007/978-3-319-17578-2 |url = http://link.springer.com/book/10.1007%2F978-3-319-17578-2}}</ref>

Lucas's model dominated new classical economic business cycle theory until 1982 when [[real business cycle theory]], starting with [[Finn E. Kydland]] and [[Edward C. Prescott]],<ref>{{Cite journal | last1 = Kydland | first1 = F. E. | last2 = Prescott | first2 = E. C. | title = Time to Build and Aggregate Fluctuations | journal = Econometrica | volume = 50 | issue = 6 | pages = 1345–1370 | doi = 10.2307/1913386 | year = 1982 | pmid = | pmc = }}</ref> replaced Lucas's theory of a money driven business cycle with a strictly supply based model that used technology and other real [[Shock (economics)|shocks]] to explain fluctuations in output.<ref>Snowdon and Vane (2005), 295.</ref>

== Theory ==

The rationale behind Lucas's supply theory centers 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 a general change in nominal prices (inflation) and what portion reflected a change in real prices for inputs and outputs.<ref name="SnowdonVane233-34">Snowdon and Vane (2005), 233–234.</ref> Lucas hypothesized that suppliers know their own industries better than the general economy. Given this imbalance in information, a supplier could perceive 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.<ref name="SnowdonVane233-34" />

The function can be represented simply as:

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== References ==

{{reflist|30em}}

== Further reading ==