Lucas and Sargent Before the New Classical Macroeconomics

1. History of Modern MacroeconomicsLecture 3.7 New Classicals and New Keynesians (1970-1985)Kevin D. HooverDepartment of EconomicsDepartment of PhilosophyCenter for the History of Political EconomyDuke University Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

2. Lucas and Sargent Before the New Classical Macroeconomics • Robert E. Lucas, Jr. (1937- ) • Chicago  Berkeley  Chicago (History  Economic History  Economics) • Keynesian education at Chicago • Early work on investment and labor in Klein’s microfoundation tradition • First job: Carnegie Tech • Thomas J. Sargent (1943- ) • Berkeley  Harvard • Politically left • Connected to Carnegie-Mellon • 16 years at University of Minnesota • Principal subject of Esther-Mirjam Sent’s The Evolving Rationality of Rational Expectations (working title: Resisting Sargent) Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

3. Carnegie Tech in the 1950s: Herbert Simon • Polymath: economist, political scientist, sociologist, psychologist • Cowles Commission: seminal work on causality and identification • Intellectual leader of Carnegie’s Graduate School of Industrial Administration • Key work on • bounded rationality • self-fulfilling expectations • investment Herbert Simon (1916-2001) Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

4. Carnegie Tech in the 1950s: Two Key Players – 1 • Franco Modigliani (1918-2003) • Nobel Laureate (1985) Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

5. Carnegie Tech in the 1950s: Two Key Players – 2 • John F. Muth (1930-2005) • Photo? If you Google Image on John F. Muth you get photos of • Lucas • Sargent • Prescott • Arrow • Simon • Samuelson • Dornbusch John Muth (1930-2005) Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

6. Carnegie Investment Planning Project Key Book: Charles C. Holt, Franco Modigliani, John F. Muth, and Herbert A. Simon. Planning Production, Inventories, and Work Force, 1960. Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

7. Muth’s Seminal Papers • “Rational Expectations and the Theory of Price Movements” (Econometrica 1961) • main theory • published second • John F. Muth. “Optimal Properties of Exponentially Weighted Forecasts” (Journal of the American Statistical Association 1960) • key example • refers to later paper in its draft form Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

8. The Rational Expectations Hypothesis expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory. . . . The hypothesis can be rephrased a little more precisely as follows: that expectations of firms (or, more generally, the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the “objective” probability distributions of outcomes). The hypothesis asserts three things: (1) Information is scarce, and the economic system generally does not waste it. (2) The way expectations are formed depends specifically on the structure of the relevant system describing the economy. (3) A “public prediction,” in the sense of Grunberg and Modigliani, will have no substantial effect on the operation of the economic system (unless it is based on inside information). [Muth 1961, p. 316] Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

9. The Cobweb and Rational Expectations Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

10. Lucas and Friedman • Non-Friedmanian Roots • Samuelson’s Foundations of Economic Analysis • receptive to Walrasian theory • preference for rigor and formal theory • Debt to Friedman • preference for radical simplification • natural rate hypothesis/expectations-augmented Phillips curve: market-clearing explanation of apparent disequilibrium based in asymmetric information Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

11. Lucas and Rapping: The First New Classical Papers • Lucas and Leonard Rapping [1933-1991]: • “Real Wages, Employment, and Inflation” (JPE 1969) • “Price Expectations and the Phillips Curve” (AER 1969) • adaptive expectations; mentions does not model rational expectations • exploitable tradeoff between inflation and unemployment • market clearing with asymmetrical information • surprise-only or Lucas aggregate supply function: y = (p – pe) • intertemporal substitution of labor Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

12. The Adoption of Rational Expectations into Macro: Key Lucas Papers • “Expectations and the Neutrality of Money” (JET 1972) • “Econometric Testing of the Natural Rate Hypothesis” (Fed Conference Volume 1972) • “Some International Evidence on Output-Inflation Tradeoffs” (AER 1973) • "Econometric Policy Evaluation: A Critique". (Carnegie-Rochester Conference Series on Public Policy 1976) Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

13. “Expectations and the Neutrality of Money” (JET 1972) • Lucas and Rapping paper in Phelps, editor. Microeconomic Foundations of Employment and Inflation Theory. • Phelps’s “island model” • Signal extraction • Stylized, but rigorous, model of the “surprise-only” aggregate supply function • The ephemeral Phillips curve • More cited than used Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

14. “Some International Evidence on Output-Inflation Tradeoffs” (AER 1973) • Empirical test of JET 1972 paper • Cross-country analysis • Implication of signal extraction: Phillips curve (aka: Lucas supply function) steeper in high variance of inflation environment • Confirmed, but contested in the literature Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

15. “Econometric Testing of the Natural Rate Hypothesis” (Fed Conference Volume 1972) • Friedman’s not really a natural rate model • regression tests the wrong test of the natural rate hypothesis (cf. Muth 1960) • correct test: overidentifying cross-equation restrictions (early example of solution methods for rational expectations models • characterizes policy by a fixed rule  proto-policy invariance critique Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

16. “Econometric Policy Evaluation: A Critique” (Carnegie-Rochester Conference Series on Public Policy 1976) • Pivotal macroeconomics paper of the second half of the 20th century • Foreshadowed by Tinbergen, Simon, Marschak, et al. (Cowles Commission) • Novelty: rational expectations as source of invariance • Critique of Tinbergen’s policy framework: • targets and instruments = engineering paradigm • can’t neglect rational action or economists inside the game • Solution • model tastes and technology  GE microfoundations essential • doing Cowles right Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

17. Sargent • Independent introduction of rational expectations • real interest rates • hyperinflation • Phillips curve • Integration of rational expectations to time-series econometrics (Sims a colleague at Minnesota) • More empirically oriented than Lucas Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

18. Sargent and Wallace: Policy Ineffectiveness – 1 • Neil Wallace (1938- ) • Chicago Ph.D under Friedman • Faculty of University of Minnesota • “Rational Expectations, the Optimal Monetary Policy and the Optimal Money Supply Rule (JPE 1975) • “Rational Expectations and the Theory of Economic Policy” (JME 1976) Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

19. Sargent and Wallace: Policy Ineffectiveness – 2 • IS-LM model with Lucas aggregate supply function + rational expectations • Pure AD policies affect output only randomly (note: nominal not real policies in question) • Fixed M rules  price level control • Interest-rate rules or feedback rules  indeterminancy • Startling, suits conservative rhetoric Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

20. Consolidation of the New Classical School • Sargent’s graduate textbook: Macroeconomic Theory 1979 • Lucas and Sargent, editors. Rational Expectations and Econometric Practice 1981 • aggregative macro/not microfoundational • emphasis on systems or GE implications of rational expectations • emphasis on econometrics Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

21. The Manifestos • Lucas and Sargent “After Keynesian Macroeconomics” (Minneapolis Fed Quarterly Review 1979) • framed as attack on Keynes despite • Keynesian roots • earlier critical targets Klein and Tinbergen • Sargent “Beyond Demand and Supply Curves in Macroeconomics” (AER 1982) • optimizing microfoundations with rational expectations • ignores earlier microfoundational programs Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

22. The Euthanasia of Macroeconomics • If these developments succeed, the term “macroeconomics” will simply disappear from use, and the modifer “micro” will become superfluous. We will simply speak, as did Smith, Ricardo, Marshall, and Walras, of economic theory. [Lucas Models of Business Cycles 1987] • The inversion of Klein’s program: • data first (analogical consistency with theory) • theory first (analogical consistency with data) Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

23. The Problem of Business Cycles • The empirical failure of the monetary shocks approach • no difference between anticipated and unanticipated money • no reaction to data revisions • unaccountable serial correlations • Ad hoc solutions • lagged dependent variables without a rationale Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

24. Lucas: A Positive Program for Business Cycles • Continuous market-clearing, dynamic equilibrium  against Keynes’s involuntary unemployment • “involuntary unemployment is not a fact or a phenomenon which it is the task of the theorist to explain. It is, on the contrary, a theoretical construct which Keynes . . . hope[d] would be helpful in discovering a correct explanation for a genuine phenomenon: large-scale fluctuations in measured, total unemployment. Is it the task of modern theoretical economics to ‘explain’ the theoretical constructs of our predecessors, whether or not they have proved fruitful?” • Business cycle phenomena: • not objects, but patterns of covariation • picked up by Kydland and Prescott • surprising respect for Burns and Mitchell Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

25. The Simulacrum Account of Models • j • j • j • pattern prediction vs. forecasting • testing rules vs. conditional forecasts • Turing and Adelman tests Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

26. The Transition to the Real Business Cycle Model • Lucas’s 1975 Business Cycle Model • growth, capital, and the propagation mechanism • the last gasp of the monetary surprises • alternative rationales for money • Kydland and Prescott, “Time to Build and Aggregate Fluctuations” • technology shocks • the absence of monetary shocks • the irrelevance of time-to-build Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

27. The Rise of the Representative Agent • The neoclassical growth model • Solow • optimal growth in the 1960s • the planning roots of the “representative agent” • Ignoring aggregation Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

28. New Keynesian Macroeconomics • Rational expectations is not the issue • Failures of new classical models to account for business cycles  • imperfections – e.g., menu costs  cost stickiness • perfectionist accounts – e.g., coordination failure, multiple equilibrium, or sunspot models • Room for policy • Saltwater/Freshwater • Off the boil Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

29. Much Left Out • Truncation of history post-1982 • Growth theory • Macro labor theory • Finance • Macroeconometrics in the VAR tradition • Monetary policy modeling • and more . . . Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

30. Thanks  The End Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)