Federal Reserve Bank of Minneapolis \ - # - SI ____ . Jjai : W-c - „: ..• - • > . C x' -y i* Spring 1999 Nobel Laureate Robert E. Lucas, Jr.: Architect of Modern Macroeconomics (p. 2) V. V. Chari Money and Debt in the Structure of Payments (p. 13) Edward J. Green Federal Reserve Bank of Minneapolis Quarterly Review vol 23, no. 2 ISSN 0271-5287 This publication primarily presents economic research aimed at improving policymaking by the Federal Reserve System and other governmental authorities. Any views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Editor: Arthur J. Rolnick Associate Editors: Edward J. Green, Warren E. Weber Economic Advisory Board: Andrew Atkeson, James A. Schmitz, Jr. Managing Editor: Kathleen S. Rolfe Article Editor: Kathleen S. Rolfe Production Editor: Jenni C. Schoppers Designer: Phil Swenson Typesetter: Mary E. Anomalay Circulation Assistant: Elaine R. 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Also, please send one copy of any publication assistant at [email protected]; editorial comments and that includes a reprint to the Minneapolis Fed Research questions, to the managing editor at [email protected]. Department. Electronic files of Quarterly Review articles are available through the Minneapolis Fed's home page on the World Wide Web: http://www.mpls.frb.org. Federal Reserve Bank of Minneapolis Quarterly Review Spring 1999 Nobel Laureate Robert E. Lucas, Jr.: Architect of Modern Macroeconomics* V. V. Charit Adviser Research Department Federal Reserve Bank of Minneapolis and Professor of Economics University of Minnesota In the late 1960s and early 1970s, Robert E. Lucas, Jr., to the development of better models. Lucas' central con- wrote a number of papers which have rightly been revered tribution was to develop and apply economic theory to spe- as modern classics. For this body of work, Lucas received cific questions in macroeconomics and to make obsolete the Nobel Prize in Economic Sciences in the fall of 1995. one class of models. With trenchant vigor and uncommon The purpose of this review is to place Lucas' work in a his- grace, Lucas argued that economic theory could be used to torical context and to evaluate the effect of this work on the illuminate old and puzzling substantive questions. economics profession. In writing this review, I have ben- Lucas' contributions are both methodological and sub- efited greatly from Lucas' (1996) Nobel lecture and from stantive. The methodological contribution is to illustrate the essay of Thomas Sargent (1996) which was written to how one goes about constructing dynamic, stochastic gen- kick off a conference held at the Federal Reserve Bank of eral equilibrium models to shed light on questions of sub- Minneapolis to celebrate the 25th anniversary of the pub- stantive economic interest. The substantive contribution is lication of Lucas' (1972) seminal paper, "Expectations and to develop and analyze a specific mechanism by which the Neutrality of Money." monetary instability leads to fluctuations in output and in- Lucas' work is sometimes heralded as revolutionary, marking the beginning of the end of Keynesian economics and the birth of rational expectations economics. This ten- *This essay is reprinted, with permission, from the Journal of Economic Per- dency to mark all key developments in economics as rev- spectives (Winter 1998, vol. 12, no. 1, pp. 171-86). © 1998 by the American Eco- olutionary is popular enough, but in my view, it is a mis- nomic Association. All rights reserved. The essay was edited for publication in the Fed- eral Reserve Bank of Minneapolis Quarterly Review. reading of the history of economic thought. My thesis is tAuthor's note: I first got to know Bob Lucas when I, as a graduate student at that Lucas' work is very much a part of the natural prog- Carnegie-Mellon, was fortunate enough to spend a year at Chicago. I still have not ress of economics as a science. Scientific progress arises gotten over being treated as an equal. I am pleased to have this opportunity to ac- knowledge my intellectual debt. Bob is a charming and delightful person, but you do from the interaction between theory and data and the de- want to be thoroughly armed in any debate with him. His rhetorical skills are formi- sire to have one unified theory to account for the observa- dable beyond belief, and since he reads widely and majored in history, it is tough to win a debate with him. I haven't, as yet, but I keep trying. A marvelous autobiography tions at hand. The search for such a theory proceeds by is available through the home page of the Nobel Foundation (http://www.nobel.se). I developing specific abstractions, or models, to understand highly recommend it. Comments from Brad De Long, Narayana Kocherlakota, Alan Krueger, and Timo- specific observations. These abstractions then lead to the thy Taylor were enormously helpful in writing this essay. The views expressed here are development of a more general theory, which in turn leads those of the author and not necessarily those of the Federal Reserve Bank of Min- to discarding models which are inconsistent with data and neapolis or the Federal Reserve System. 2 V. V. Chari Nobel Laureate Robert E. Lucas, Jr. flation. It is hard to overemphasize the contribution to comes depend upon the actions of everyone in society, method. Economists today routinely analyze systems in agents must form expectations about the actions of others which agents operate in complex probabilistic environ- and, indeed, expectations about the expectations of others, ments in order to understand interactions about which the and so on. This feature can be captured by the notion of great theorists of an earlier generation could only specu- equilibrium. late. This sea change is due in substantial part to Lucas. The equilibrium postulate is a convenient and powerful way of summarizing these expectations and ensuring con- The Theoretical Foundations sistency in decision making. As the name suggests, equi- of Macroeconomics librium is the rest point of a system, and it was conven- By the 1960s, the models used in macroeconomics de- tional to think of this rest point in terms of quantities and scribed the aggregate economy as consisting of a system of prices. However, this conventional view is not particularly equations: one equation to describe consumption, one to helpful in thinking about a world which is continually buf- describe investment, one to describe money demand, and feted by shocks. In such a world, the sensible way to so on. Each of these equations was loosely thought of as think about decision problems is as formulating decision arising from a deeper formulation of individual or firm de- rules or contingency plans for choosing actions which cision making. This approach was attractive because the depend upon agents' information. The central theoretical models were mathematically explicit and the parameters of breakthrough of the last 50 years is that economists now the equations could be estimated using the powerful econo- think of equilibrium as a rest point in the space of deci- metric procedures that had been developed in the postwar sion rules. This breakthrough appeared in die most the- era under the influence of the Cowles Commission. These oretical and abstract reaches of the discipline in the work macroeconometric models were widely used for answering of John Nash (1950) in game theory and the work of Ken- questions such as, How does the conduct of monetary poli- neth Arrow (1951) and Gerard Debreu (1959) in the theory cy affect output, inflation, and unemployment? A growing of competitive equilibrium. Lucas is perhaps the foremost consensus in economics viewed these models as fitting the recent developer and expositor of this view. Thinking of behavior of the U.S. economy and as suitable for generat- equilibrium as a rest point in the space of decision rules ing answers to policy questions; for an expression of this has given economists the conceptual framework to analyze confidence, see Franco Modigliani's (1977) presidential a bewildering variety of environments in which dynamics address to the American Economic Association. At the and uncertainty play central roles. same time, the desirability of making specific the relation- The contrast between the theoretical foundations of the ship between macroeconometric models and microeco- 1960s-style macroeconometric models and those of mod- nomic theory was widely recognized. That is, macroeco- ern models is stark; the book edited by Thomas Cooley nomics needed theoretical foundations. (1995) is a collection of papers which illustrate the style of The chief difficulty in developing these foundations was modern macroeconomic modeling. The earlier generation that macroeconomic questions necessarily involve dealing of macroeconometric models was frequently rationalized with dynamics and uncertainty. An individual choosing as representing the equilibria of static general equilibrium how much to spend today is necessarily making a choice models together with tacked on dynamics representing of how much to consume in the future.