On Robert Lucas’s Expectations, a Central Feature of Modern Macroeconomics, and On His “Lucas Critique” of Hydraulic Keynesianism

The rational expectations revolution, which led to modern macroeconomics, did further damage to hydraulic Keynesianism. Following Muth (1961), Lucas (1972, 1976) articulated what would become the central feature of modern macroeconomics: expectations are formed as if the representative agent knows the true model, and the ‘true’ model is whatever the theorist says it is. The limits of rational-expectations modelling probably seem more important today than they did before the financial crisis of 2007 and 2008. At the time of the rational-expectations revolution, however, it offered a valuable correction to the more mechanical sort of macroeconomics that had previously dominated policy.

Lucas (1976) pointed out a problem with hydraulic Keynesianism. The theory assumes that the different functions being estimated would not change when policy changed. But those functions reflected the plans and actions of people who are trying to understand the economy in which they act. For that reason, the functions may not have the sort of stability required for the theory to work. In particular, the public will sooner or later catch on to the link between expansionary monetary policy and inflation rates. When they do, inflation will no longer reduce unemployment. Anticipating increases in inflation, workers may not imagine that their higher wages represent more purchasing power, suppliers may not mistake an increase in output prices for an increase in underlying demand for their goods, and so on. The public will protect itself from the expected inflation, thereby eliminating the supposedly beneficial effects. This criticism of hydraulic Keynesianism is the ‘Lucas critique’.

—Roger Koppl, From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: Institute of Economic Affairs, 2014), 44-45.