Lucas’s methodological divide in inflation theory: a student’s journey

ABSTRACT

The paper describes how Robert E. Lucas, Jr.’s monetary economies are based on his methodology of using a single general equilibrium dynamic optimization model with microeconomic foundations that can be tested with econometric methods. It shows how, since his 1972 neutrality paper, Phillips curves continue to be a foundation for policy prescription contrary to Lucas’s 1972 results. In support of Lucas’s hypothesis, historical Phillips curves are shown to be idiosyncratic rather than a basis for policy. Using Lucas’s alternative microfounded approaches to money, growth, and asset pricing, the paper then presents Lucas-type extensions for money and growth using a microfounded bank production of exchange credit as an alternative to money, as suggested by Lucas. The paper also shows how this leads to endogenous velocity, money causing inflation, and inflation causing lower economic growth, as in evidence. This implies that Lucas-based low stable inflation policy yields high economic growth and employment.

KEYWORDS:

• Phillips curve
• microfoundations
• dynamic general equilibrium
• cash-in-advance economy
• velocity
• endogenous growth

Acknowledgements

I gratefully acknowledge support of the University of Missouri – St. Louis F. A. Hayek Professorship endowment fund, and comments by editor Peter Galbács, the referees, and Michal Kejak.

Disclosure statement

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

Notes

1 The emphasis on the testing of hypotheses was often attributed to Milton Friedman by, among others, George Schultz in his featured interview at the Mont Pelerin Society 40th Anniversary meeting, Hoover Institute, January 2020.

2 My PhD dissertation was supervised by Lucas.

3 I thank a referee for this point.

4 Gillman and Nakov (2009), Alquist et al. (2013) and Benk and Gillman (2020) find Granger causality of real oil prices from US money supply, US inflation, and US expected inflation, as well as from money to inflation. This causality has recently been phrased as Granger ‘predictability.’

5 See also McCallum’s (1983) related critique.

6 See for example Venkateswaran and Wright (2014).

7 This fraction echoes back to Tobin’s (1965) model of money demand where a fraction of assets is held as money, and another fraction is held as bonds.

8 Lucas distributed a draft in mimeo form of the CIA economy, in one of his Topics class, that also includes an extended section on credit which L80 omits, but may be related to Atkeson and Lucas’s (1992) pure credit economy.

9 The microeconometric bank literature by Hancock (1985), Berger and Humphrey (1997), Degryse et al. (2009) or Wheelock and Wilson (2009) uses Clark’s (1984) approach. By contrast, Aiyagari et al. (1998) use King and Plosser’s (1984) approach to study econometrically how international inflation rate increases lead to increases in bank exchange credit services.

10 There is a disagreement over the stability of the demand for money. Reynard (2004) discusses how financial intermediation can cause money demand to appear instable, while Berentsen et al. (2015) present stable money demand evidence using a new monetarist model.

11 See Csabafi and Gillman (2021) for the 1975–2020 period.

12 See Maio and Silva (2020) for other neoclassical approaches to the bond pricing kernel, including money-in-the-utility function, the cash-good/credit-good economy, and a transaction cost economy.

Additional information

Funding

This work was supported by University of Missouri-St. Louis.

Notes on contributors

Max Gillman

Max Gillman is the F. A. Hayek Professor in Economic History at the Department of Economics, the University of Missouri – St. Louis. Previously he was Professor of Economics at Cardiff Business School and Central European University. He is an Associate Researcher in the Hungarian Academy of Sciences in Budapest (CERS HAS), and at CERGE-EI in Prague, and has been a visiting scholar at New York University, the Federal Reserve Banks of St. Louis, Atlanta, and Minneapolis, and the University of Chicago, where he did his Ph. D. thesis entitled ‘The time value of money’. He has authored over 40 journal articles and three books: Principles of macroeconomics—An evolutionary approach (2017, Kendall Hunt), Advanced modern macroeconomics: Analysis and application (2011, Pearson) and Inflation theory in economics—Welfare, velocity, growth and business cycles (2009, Routledge). He also edited Robert E. Lucas’s Collected papers on monetary theory (2011, Harvard University Press). Currently his research focuses on inflation theory, business cycles, banking, money, asset prices, and growth.