Robert E. Lucas - The Completion of an Era in New Classical Economics

(September 15, 1937 – May 15, 2023)

The mid-20th century was characterized by Keynesian propositions favoring demand-side economics and the impact of government intervention in improving the economic standards of its citizens. By the 1970s, stagflation became a prominent threat among the world’s most developed economies and Keynesian ideas did little to avert them. A new trend named ‘supply-side’ economics advocated for the increase in aggregate supply by producing more goods, which reduces prices, thereby encouraging consumers to purchase more. Robert Emerson Lucas Jr. (a New Classical economist) first showed that confidence possessed by human beings under present circumstances reflected in decisions taken over future events. It is termed as ‘expectations.’ Human beings utilize whatever information is available and compare it with the experience gained from previous events. This established the tenets of the ‘Rational-Expectations’ theory.

‘Rational Expectations’ (RE) Theory

Previous theories of to RE approach heavily focused on a fixated approach for example, if inflation rates stood at 5.75% for the last three years, then it's assumed that the public perception towards the rates for the fourth year would be concurrent. Lucas said that this level of irrationality does not persist in modern-day economies. Individuals will always scrutinize their past mistakes and use their aptitude while analyzing economic trends. The relevance of rational expectations holds true as individuals become more ambitious while dealing with future events. This rationality level might not be apt for establishing the precise economic model, but it still enables the individual to understand whether the gains derived were far better than the prices involved. This theory provided the basis for interpreting inflation cycles, capturing the trend of business cycles, and testing the efficient-market hypothesis.

Policy-level Implications of RE Theory

Governments of various nations have either proposed tax cuts or freebies to the public aims at increasing higher financial prospects. In the short run, this policy works well by giving more cash and goodies to the people enabling them to purchase more and contribute greatly towards employment generation. Using the RE approach for the long-run analysis, one can deduce that these tax cuts will force an increased fiscal burden causing budget receipts to fall while the budget outlay remains in stasis.

This would lead the authorities to factor in higher tax rates by the next budget session just for compensating the deficits incurred. When placed in a situation like this, people would think differently by further decreasing their expenditures and prefer saving the excess cash received during the tax cuts. With more cash saved by the public and left unutilized, it will destroy the government’s plan set aside for economic activity generation.

Take another scenario wherein the central bank decided to improve the economic situation by injecting more money to promote various financial activities. Also, a change in information about the change in employment levels and money supply is presented to the public. Using Lucas’ model depicts that people would take a rational decision based on the extra knowledge now obtained. Therefore, employees will push for higher wages, and enterprises swell up market prices, to just counteract the inflationary pressures.

For his ground-breaking work, Robert Lucas won the Nobel Prize in Economics (1995).