Lucas aggregate supply function: Difference between revisions

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== Theory ==

The rationale behind Lucas's supply theory centers on how suppliers get information. Lucas claimed that suppliers had to respond to a "signal extration" 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>Snowdon and Vane, 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|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>Snowdon and Vane (2005), 233-234.</ref>

The function can be represented simply as: