Introduction to the Mini-Symposium on Lucas’s 1972 ‘Expectations and the Neutrality of Money’ in Historical Perspective

ABSTRACT

This is the general introduction to a mini-symposium on Lucas’ (1972) ‘Expectations and the neutrality of money’ in historical perspective. Upon discussing some of the main features of Lucas’ seminal and controversial article, this introduction sums up the main points of the four papers contributed to the mini-symposium.

KEYWORDS:

• Lucas
• expectations
• monetary neutrality
• historical perspective

JEL CODES:

• B22
• E32

The four articles gathered in this mini-symposium are fully revised versions of papers originally presented at a session held at the December 2021 meetings of the History of Economics Society, which contributed new historical insights about Robert Lucas’s 1972 ‘Expectations and the neutrality of money’, nearly 50 years after its publication. The 50th anniversary of Lucas’s seminal (if controversial) article has prompted as well a roundtable featuring historians of thought and macroeconomists at the October 2021 meetings of the European Society for the History of Economic Thought — published in 2022 as a transcript in the European Journal of the History of Economic Thought (vol. 29, issue 6) — and a special issue of the Journal of Economic Methodology edited by Peter Galbács in March 2022, with contributions by practicing macroeconomists, historians and methodologists. Lucas (1937-2023) passed away earlier this year.

Lucas’s 1972 article changed the course of macroeconomics as it marked the first successful challenge to Paul Samuelson’s (1947) separation between static optimization-based economic problems and macroeconomic dynamics. That division had been a hallmark of the ‘neoclassical synthesis’, a term famously coined by Samuelson in the 1950s. The ‘synthesis’ dominated macroeconomics from the post-war period until Lucas disputed such theoretical tradition that had left the dynamics of adjustment accounted for by factors other than the choice-theoretic framework (see also Boianovsky 2020). Whereas Samuelson had argued that aggregate behaviour could be neither understood as the result of maximization problems nor converted into this form, Lucas put forward a dynamic optimization methodology based on his new concept of stochastic contingent-claim equilibrium.

Lucas (1972) formally characterized equilibrium as a fixed point in the mapping from beliefs to laws of motion of the state variables. The expectations function described how prices depend on exogenous disturbances or shocks, whereas the pricing function depicted how actual prices are affected by those shocks. The solution to the functional equation — formed by the mapping of the expectation function into the space of pricing functions — is a fixed point where the expectation function and the price function accord, which has been labelled ‘rational expectations equilibrium’, in Muth’s (1961) sense. Lucas’s new concept of equilibrium prices as functions of the set of states of the world in stochastic equilibrium opened the possibility to investigate economic systems that were in equilibrium and yet featured business cycles driven by random shocks, such as changes in money supply. Supply and demand in each market are equal in each period if they are measured conditional upon agents’ available information.

Such methodological innovations by Lucas proved to be more durable — especially with their offspring embodied by the celebrated ‘Lucas Critique’ that economic models should in principle be based on optimization analysis of agents’ behaviour and therefore invariant to economic policy changes (Lucas 1976) — than Lucas’s (1972) overlapping generations monetary model of how disparate information among individuals may cause sluggish price or wage adjustment to emerge as reactions to monetary shocks in an otherwise perfectly flexible prices economy. In view of theoretical and empirical problems that beset his model of ‘monetary misperceptions’, Lucas was eventually attracted to rational expectations models featuring contractual price rigidities in goods and labour markets (see also Laidler 2021; Boianovsky 2022).

Moreover, dynamic stochastic general equilibrium (DSGE) models, of the kind introduced by Lucas and further elaborated by Kydland and Prescott’s (1982) real business cycle approach, were based on the double notion that business cycles, as described by the behaviour of co-movements among time series, ‘are all alike’, with a ‘recurrent’ pattern (Lucas 1977). This warranted the application to business cycle analysis of Muth’s (1961) identification of individuals’ subjective probabilities with the observed frequencies (‘true’ probabilities), that is, rational expectations. The latter concept is not applicable, as Lucas (1977) pointed out, to situations when it is not possible to guess which observable frequency is relevant — that is, situations of Knightian uncertainty. It was only when Knightian risk, instead of uncertainty, prevailed that the hypothesis of rational behaviour, as explainable by economic theory, made sense, Lucas observed. In particular, agents may then be assumed to react to cyclical fluctuations as ‘risk’, with rational expectations formed in a stable environment of information gathering and processing (see also Gerrard 1994 on Lucas and Keynes on uncertainty). Significantly, Lucas acknowledged that sharp downturns, such as the Great Depression of the 1930s and the 2008 financial crisis, were outside the scope of dynamic stochastic equilibrium models that evolved from his 1972 JET article.

The papers assembled in this mini-symposium explore new historical perspectives regarding Lucas’s (1972) paper, its aftermath and some anticipations of his monetary misperception hypothesis. Dimand and Rivot show how Lucas’s new theoretical framework led James Tobin and Milton Friedman, respectively, to change significant aspects of their own approaches to monetary economics. Tobin was the leading Keynesian economist who paid close critical attention to Lucas’s theoretical and methodological innovations, which led to an exchange between them that extended over 1972–1981. The strength of Lucas’s arguments eventually led Tobin to emphasize how faster price adjustment could be destabilizing, along the lines of Fisher’s debt-deflation and chapter 19 of Keynes’s General Theory.

From the monetarist side, Friedman – whose original concept of the natural rate of unemployment under adaptive expectations had (together with E. Phelps’s) a deep influence on Lucas — was also led to strengthen his arguments about monetary policy rules, as he reacted to Lucas’s rational expectations setting and recalled his own approach to probability based on subjective uncertainty. Lucas’s claim – that his new approach to monetary macroeconomics was built on the solid micro-foundations grounds of general equilibrium (GE) theory — is disputed by Ingrao, who argues that Lucas and other New Classical economists overlooked two main problems with GE analysis: (i) the troubles in achieving uniqueness and stability theorems and (ii) the challenge of the role of money in GE models, both discussed since the 1960s and 1970s. Historically, Lucas’s ‘signal extraction problem’ — that is, the difficulty economic agents face as they try to distinguish between changes in relative prices and in the price level, due to temporary misinformation – may be found already in the writings of J.S. Mill, W. Roscher and D.H. Robertson, who all recognized its significance for output fluctuations. Boianovsky documents how those mid 19th and early 20th century economists developed such concepts, and why their contributions were acknowledged in the literature only after Lucas (1972) put forward his formal model of monetary non-neutrality.

Disclosure Statement

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