Lucas and Friedman: The Challenges of Rational Expectations-Based Monetary Cycles for Adaptive Expectations-Based Monetary Long Trends

ABSTRACT

The paper argues that Lucas (1972. ‘Expectations and the Neutrality of Money.’ Journal of Economic Theory 4 (2): 103–124) played a significant role in changing Friedman’s theoretical propositions of the 1970s, and that his restatement of Friedman’s (1968b. Dollars and Deficits. Inflation, Monetary Policy and the Balance of Payments. Englewood Cliffs: Prentice-Hall International) address on monetarism helped Friedman refine his argument, regarding both theory and policy-making, in a consistent manner. First, the adoption of the rational expectations hypothesis eventually led to a confrontation with Friedman, whose own approach to probability, based on subjective uncertainty, originated in his early joint work with Savage. Second, Lucas’ modelling of the aggregate supply function undermined Friedman’s earlier approach to the interrelationships between prices and quantities, but also helped remind Friedman of his Marshallian lineage. Lastly, Lucas’s monetary cycle theory, based on an extraction signal problem that was quickly criticized and abandoned, compelled Friedman to give a firmer theoretical foundation to his monetary policy rule based on a constant rate of growth in money supply, thanks to his earlier approach of subjective uncertainty and personal probability.

KEYWORDS:

• Expectations
• monetary cycles
• monetary policy
• monetary trends
• Phillips curve

JEL CODES:

• B22
• B31

Acknowledgements

The author would like to thank two anonymous referees for their helpful comments.

Disclosure Statement

No potential conflict of interest was reported by the author(s).

Notes

1 See for example Friedman (1948 [1953], 1956 [1987], 1958 [1969], 1961 [1968]).

2 On this issue, see Rivot (2021).

3 See for example Friedman (1966a [1968], 1966b, 1968a [1969], 1972).

4 This appraisal of Sims’ empirical works partly contradicts Friedman’s initial appraisal of the empirical work of Cowles Commission members when it was located in Chicago (Dimand and Rivot 2021).

5 In a footnote in Nelson (2020, ch. 15 p. 447 fn. 259) there is an argument about an unpublished paper from 1978 that ‘contained one of the most extended discussions of rational expectations’, yet without further explanation. In that footnote, Nelson also argues: ‘But being unpublished and low in circulation, it was little noted. An exception was the fleeting mention given by Hoover (1984, p. 61), who presumably received the paper in the course of the correspondence with Friedman on rational expectations that Hoover acknowledges’.

6 Friedman and Schwartz referred to Brunner, Cukierman, and Meltzer (1980) and the working paper version dated 1980 of what would become Brunner, Cukierman, and Meltzer (1983).

7 Lucas earned his PhD from the University of Chicago in 1964, moved to Carnegie Mellon University, and moved back to Chicago in 1974.

8 See Rivot (2018).

9 There are ‘lags of response’, which are of three different kinds: ‘(1) the lag between the need for action and the recognition of this need; (2) the lag between recognition of the need for action and the taking of action; and (3) the lag between the action and its effect’ (Friedman 1948 [1953] p. 145).

10 ‘(…) although Friedman continued to be an active participant in economic discourse after 1972 (from his bases of the University of Chicago up to the 1976–1977 academic year and of the Hoover Institution, Stanford University, thereafter), a very large amount of his post-1972 participation was via public policy and popular forums rather than via contributions to the research literature’ (Nelson 2020, vol. 1, p. ix).