Back in 1972, Robert E. Lucas (Nobel ’95) published a paper called “Expectations and the neutrality of money,” in the Journal of Economic Theory (4:2, 103–124). The paper was already standard on macroeconomics reading lists when I started graduate school in 1982, and I suspect it’s still there. For the 50th anniversary, the Journal of Economic Methodology (22:1, 2022) has published a six-paper symposium on Lucas’s work and the 1972 paper in particular.

Reading the heavily mathematical 1972 paper isn’t easy, and summarizing it isn’t easy, either. But at some substantial risk of oversimplifying, it addresses a big question. Why does policy by a central bank like the Federal Reserve affect the real economy? In the long-run, there is a widely-held belief (backed by a solid if not indisputable array of evidence) that in the long-run, money is a “veil” over real economic activity: that is, money facilitates economic transactions, but at over time it is preferences and technologies, working through forces of supply and demand, that determine real economic outcomes. To put it another way, changes in money will alter the overall price level over long-term time horizons, but it is “neutral” to real economic outcomes.

However, when the Federal Reserve or other central banks conduct monetary policy, it clearly does have an effect on the real economy. When a central bank lowers interest rates and makes credit available in a recession, the length of the recession seems diminished. Today, the concern is that if the central bank raises interest rates, it may cause an economic slowdown or recession. Apparently money is not just a veil over real activity, at least not in the short-run. But why not?

One possible answer here is that people are bad at anticipating the future. Thus, when the Fed stimulates the economy in the short-run, people don’t recognize that this stimulus might lead to inflation. When the Fed was spurring the economy during the pandemic recession in 2020 and into 2021, relatively few people were anticipating higher inflation. But for economists, the theory that monetary policy depends on people and markets being perpetually bad at understanding what’s going on feels like, at best, a partial answer.

Thus, in the 1972 paper, Lucas tried a different approach. He wanted to construct an example–that is, a model–of an economy where all the agents are fully rational. For economists, “rational” doesn’t mean you are always correct. It just means that you take advantage of all available information in making decisions–and as a consequence, you won’t make the same mistake over and over again. Thus, the central bank can’t “fool” these rational agents by juicing up the economy with low interest rates.

However, that phrase “all available information” opens up a possibility. What if economic agents do not and cannot have full information about what’s happening in the economy? In particular, say that when a number of prices rise, it’s hard for an economic agent to know if this is a “real” change because of forces of supply and demand or if it’s a “monetary” change of generally higher price levels. In summer and fall 2021, for example, it was hard to tell whether the higher prices were a “real” result of supply chains fracturing, or a “monetary” result of an overstimulated economy and a generalized inflation.

At the end of the 1972 paper, Lucas writes:

These rational agents are thus placed in a setting in which the information conveyed to traders by market prices is inadequate to permit them to distinguish real from monetary disturbances. In this setting, monetary fluctuations lead to real output movements in the same direction. In order for this resolution to carry any conviction, it has been necessary to adopt a framework simple enough to permit a precise specification of the information available to each trader at each point in time, and to facilitate verification of the rationality of each reader’s behavior. To obtain this simplicity, most of the interesting features of the observed business cycle have been abstracted from, with one notable exception: the Phillips curve emerges not as an unexplained empirical fact, but as a central feature of the solution to a general equilibrium system.

This Lucas paper is heavy on mathematics and will be a tough read for the uninitiated. It has come to be called an “island economy,” although the word “island” doesn’t actually appear in the 1972 paper, because in a mathematical sense the economic actors have a hard time distinguishing between what is on their own “island” and the broader economy. Information is spread out. It’s hard to perceive accurately what’s happening.

The emphasis on what information people have, and how they form their expectations about inflation–when filtered through decades of research since 1972–has had a substantial effect on real-world economic policy is conducted. It meant that monetary policy had a greater emphasis on expectations of inflation and how those expectations are formed. At present, for example, a key question for the Federal Reserve is the extent to which expectations of a higher inflation rate are becoming embedded throughout the economy in price-setting, wage-setting, and interest rates–because entrenched inflationary expectations would pose a different policy problem. The emphasis in monetary policy about rules that will be followed over time (like at target inflation rate of 2%) or “forward guidance” about how monetary policy will evolve in the future are both focused on addressing people’s expectations about future inflation. Keeping central banks reasonably independent from the political process can also be viewed as a way of reassuring people that even if politicians with a short-run focus control federal spending and borrowing, the central bank will be allowed to follow its own course–which again influences the expectations that people have about future inflation.

I should add that the Lucas (1972) paper became just one in a vast literature exploring the reasons why it might be hard for people to distinguish between changes in prices that arise from supply and demand and the changes that are part of an overall inflation. For example, some prices might be preset for certain time by past contracts, and when you know that some prices cannot adjust for a certain time, but others can, figuring out the real and monetary distinctions again become tricky.

In the Journal of Economic Methodology symposium, my guess is that a number of economist-readers may be most interested in the personal essays by Thomas J. Sargent (Nobel ’11) on “Learning from Lucas” and Harald Uhlig on “The lasting influence of Robert E. Lucas on Chicago economics,” both of which are fully of descriptions of how Lucas influenced the intellectual journey of the authors.

I found particular interest in the first essay in the symposium, “Lucas’s way to his monetary theory of large-scale fluctuations,” by Peter Galbács. The focus here is not on the legacy of Lucas’s work but on the earlier research leading up to it. Some of this ground is also covered in Lucas’s Nobel lecture on “Monetary Neutrality.” Galbács writes in the conclusion:

The way Lucas arrived at his monetary island-model framework was thus a step-by-step process starting in the earliest stage of his career. The first step was the choice-theoretic analysis of firm behaviour. At this stage, Lucas’s focus was on the firm’s investment decision through which he distinguished short-run and long-run reactions of the firm and the industry. The climax of this period is his Adjustment costs and the theory of supply (Lucas, 1966/1967a) that contained the basic supply and-demand framework that Lucas and Rapping (1968/1969a; 1968/1969b; 1970/1972a) shortly extended to labour market modelling – so Lucas’s work with Rapping is rooted in his earlier record in firm microeconomics. As they assumed, the household decides on short-run labour
supply on the basis of a given set of price and wage expectations, while it adjusts to long-run changes with a firm-like investment decision that implies the revision of expectations.

After this second step taken in labour market modelling, the third stage realizing his Expectations and the neutrality of money (Lucas, 1970/1972a) directly followed – although the complexity of influences renders the connection with the previous phase subtle (Lucas, 2001, p. 21). His monetary island model was a ‘spin-off’ from his work with Rapping (Lucas’s letter to Edmund S. Phelps, November 7, 1969. Box 1A, Folder ‘1969’), but the paper may be more appropriately regarded as a spin-off from the related impressions Lucas received. First of all, he needed the very island-model framework. It is Phelps (1970, pp. 6–9) who called his attention to the option of reformulating the decision problem by scattering the agents over isolated markets, while it is Cass who led Lucas to a correct mathematical exposition. However, it is Prescott who in their collaboration prepared Lucas for this exposition; and it is also Prescott who, teamed up with Lucas, provided the paradigmatic example of applying the Muthian rational expectations hypothesis in a stochastic setting with which Lucas (1966/1981b) had formerly dealt only in the less interesting non-stochastic case. As the present paper argued, Lucas’s monetary island model is thus the unification of the impressions Lucas gained under his graduate
studies at the University of Chicago, and later from Rapping, Phelps, Cass and Prescott under his years at Carnegie Mellon University

Here’s the full Table of Contents for the symposium, which requires a subscription to access: