No Such Thing as a Free Lunch: Principles of Economics (Part 170)

We have the most flexible and adaptive economy. Making sure we sustain the ability of the American economy to perform well is really the priority of economic policy.

John W. Snow

Debates in Macroeconomics

(Part E)

by

Charles Lamson

 The Lucas Supply Function

Lucas begins by assuming people and firms are specialists in production but generalists in consumption. If someone you know is a manual laborer, the chances are she sells only one thing---labor. If she is a lawyer she sells only legal services. In contrast, people buy a large bundle of goods---ranging from gasoline to ice cream and pretzels---on a regular basis. The same is true for firms. Most companies tend to concentrate on producing a small range of products, but they typically buy a larger range of inputs---raw materials, labor, energy, and capital. According to Lucas, this divergence between buying and selling creates an asymmetry. People know much more about the prices of the things they sell than they do about the prices of the things they buy.

At the beginning of each period, a firm has some expectation of the average price level for that period. If the actual price level turns out to be different, there is a price surprise. Suppose the average price level is higher than expected. Because the firm learns about the actual price levels slowly, some time goes by before it realizes all the prices have gone up. The firm does learn quickly that the price of its output has gone up. The firm perceives---incorrectly, it turns out---that its price has risen relative to other prices, and this leads it to produce more output.

A similar argument holds for workers. When there is a positive price surprise, workers at first believe their "price"---their wage rate---has increased relative to other prices. Workers believe their real wage rate has risen. We know from theory that an increase in the real wage is likely to encourage workers to work more hours. The real wage has not actually risen, but it takes workers a while to figure this out. In the meantime, they supply more hours of work than they would have. This means the economy will produce more output when prices are unexpectedly higher than when prices are at their expected level.

This is the rationale for the Lucas supply function. Unexpected increases in the price level can fool workers and firms into thinking relative prices have changed, causing them to alter the amount of labor or goods they choose to supply.

Policy Implications of the Lucas Supply Function The Lucas supply function in combination with the assumption that expectations are rational (The rational-expectations theory posits that individuals base their decisions on three primary factors: their human rationality, the information available to them, and their past experiences.) implies that anticipated policy changes have no effect on real output. Consider a change in monetary policy. In general, the change will have some effect on the average price level. If the policy change is announced to the public, then people know what the effect on the price level will be, because they have rational expectations and know the way changes in monetary policy affect the price level. This means the change in monetary policy affects both the actual price level and the expected price level in the same way. The new price level minus the new expected price level is zero---no price surprise. In such a case, there will be no change in real output, because the Lucas supply function states that real output can change from its fixed level only if there is a price surprise.

The general conclusion is that any announced policy change in fiscal policy or any other policy has no effect on real output, because the policy change affects both actual and expected price levels in the same way. If people have rational expectations, known policy changes can produce no price surprises---and no increases in real output. The only way any change in government policy can affect real output is if it is kept in the dark so it is not generally known. Government policy can affect real output only if it surprises people; otherwise, it cannot. Rational-expectations theory combined with the Lucas supply function proposes a very small role for government policy in the economy.

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 656-657*

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