David Fettig
Editor

Back in the early 1970s, Neil Wallace, then a research consultant at the Federal Reserve Bank of Minneapolis and a professor of economics at the University of Minnesota, was working on large models of the U.S. economy that were used to analyze and forecast the effects of alternative government policies on the economy. These were popular models, based on decades-old theory that consumers and businesses did not adapt their behavior to a particular government policy, such as countercyclical monetary policy, and that the government could expect its actions to have a definite, predictable result.

One day, after reading a paper by the economist Robert Lucas, Wallace walked into the office of another Minneapolis Fed research consultant and U of M professor, Thomas Sargent, and announced that everything the two economists had learned until then would have to be thrown out the window. It was time to learn new things. As Sargent later wrote: "We were stunned into terminating our long-standing Minneapolis Fed research project."

Once in a while a paper comes along, in economics or any discipline, that changes how people view the world. And that, generally speaking, is the kind of impact that Lucas' work, "Expectations on the Neutrality of Money," had in the field of economics, says S. Rao Aiyagari, Minneapolis Fed senior research officer. "It is unthinkable today to analyze questions in macro and monetary economics in the old pre-Lucas way," Aiyagari says.

Essentially, what Lucas' analysis showed is that the expectations of consumers and businesses change when government alters its policy; therefore, predictions about the effects of the government's actions would have to be radically changed. Known as Rational Expectations, this idea was not new when Lucas wrote his paper, but he was the first to apply Rational Expectations in a rigorous economic model, to place the idea within the context of existing theory, and to suggest a new basis for analyzing economic policies.

Until Lucas' paper, it was generally assumed that there was a trade-off between inflation and unemployment; that is, if the government was willing to tolerate higher inflation, it could reduce unemployment, and if the government wanted lower inflation, its actions would raise unemployment. "Lucas showed that the average unemployment rate won't change at all, regardless of whether the government pursues a more or less inflationary policy," Aiyagari says. This occurs because when the government pursues an inflationary policy, for example, consumers and businesses start expecting higher inflation. "The workers will then demand, and the employers will find it profitable, to simply raise wages to keep up with inflation, without any change in employment or GDP," he says, and offers the mid- to late-'70s as an example of this phenomenon.

In recognition of Lucas' paper, which was written in 1970 but not published until two years later, Aiyagari organized a 25th anniversary conference earlier this year at the Minneapolis Fed. Just months after it was held, the importance of the conference's subject was affirmed when Lucas received the Nobel Prize in Economics. "I have organized other conferences at the Fed before, but this one clearly will leave a warm memory in my mind for years," Aiyagari says.

Over 60 economists from around the world attended the conference, including three who are currently senior research consultants at the Minneapolis Fed and who did important work on Lucas' ideas: Edward Prescott, professor of economics at the University of Minnesota; and the previously mentioned Wallace, now Barnett Banks Professor of Money and Banking at the University of Miami, and Sargent, senior fellow at the Hoover Institution.

Nine papers were presented at the conference, on such topics as monetary theory and policy, business cycles, fiscal policy, consumption taxes vs. income taxes, productivity decline during the 1970s and others. The papers will be published in a special issue of the Journal of Monetary Economics next spring.

When Lucas wrote his ground-breaking paper, he hoped to have it published in the American Economic Review, the official journal of the American Economic Association. But the paper was rejected because it was too technical. That may sound extraordinary today, when economics papers have become mathematically advanced, but 25 years ago economics wasn't as technically sophisticated as it is today, Aiyagari says. After that initial rejection, Lucas submitted his paper to the Journal of Economic Theory, where it was published.

The coherence of Lucas' ideas, along with his development of mathematical, statistical and computational methods, means that his original paper has held up well over time, Aiyagari says. Today, economists now incorporate Lucas' insights into their models as they work toward the goal of accurately forecasting the effects of alternative government policies. Attainment of that goal has been aided by ideas such as Lucas', as well as by advances in technical methods, but the effort is still a difficult task. "This is ongoing work and will take many more years," Aiyagari says.

In his paper prepared for the Lucas anniversary conference, Thomas Sargent writes: "It took us longer than we like to recall to understand how thoroughly the idea of Rational Expectations would cause us to change the way we did macroeconomics." Lucas' paper "displaced the older distinction between short and long runs in favor of one between expected and unexpected outcomes. The power of that paper resides in the ways it mixes respect for previous work ... with shrewd analytical choices ... to make sharp new statements about empirical work and the design of counter cyclical government polices..