Lucas aggregate supply function
Encyclopedia
The Lucas aggregate supply function or Lucas 'surprise' supply function, based on the Lucas imperfect information model, is a representation of aggregate supply
based on the work of new classical
economist Robert Lucas
. The model states that economic output is a function of "money" or "price surprise." The model accounts for the empirically based trade off between output and prices represented by the Phillips curve
, but the function breaks from the Phillips curve since only unanticipated price level changes lead to changes in output. The model accounts for empirically observed short-run correlations between output and prices, but maintains the neutrality of money
(the absence of a price or money supply relationship with output and employment) in the long-run. The policy ineffectiveness proposition
extends the model by arguing that, since people with rational expectations
cannot be systematically surprised by monetary policy
, monetary policy cannot be used to systematically influence the economy.
(1969). In this earlier model, supply (specifically labor supply) is a direct function of real wages: More work will be done when real wages are high and less when they are low. Under this model, unemployment is "voluntary." In 1972 Lucas made a second attempt at modelling aggregate demand. This attempt drew from Milton Friedman
's natural rate hypothesis that challenged the Phillips curve. Lucas supported his original, theoretical paper that outlined the surprise based supply curve with an empirical paper that demonstrated that countries with a history of stable price levels exhibit larger effects in response to monetary policy than countries where prices have been volatile.
Lucas's model dominated new classical economic business cycle theory until 1982 when real business cycle theory
replaced Lucas's theory of a money driven business cycle with a strictly supply based model that used technology and other real shocks to explain fluctuations in output.
for its output, reflecting a better, real price for its output and encouraging more production. The surprise leads to an increase in production and employment throughout the economy.
The function can be represented simply as:
The simple version models aggregate output as a function of the price surprise. A more complicated expression of the Lucas supply curve adds expectations to the model. Aggregate supply is a function of the natural rate of output(
) and the difference between actual prices (
) and the expected price level given past information 
times a coefficient based on an economy's sensitivity to price surprises (
):
By invoking Okun's law
to express the function in terms of unemployment, Lucas's supply function can be viewed as an expression of the expectations-augmented Phillips curve.
Aggregate supply
In economics, aggregate supply is the total supply of goods and services that firms in a national economy plan on selling during a specific time period...
based on the work of new classical
New classical macroeconomics
New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics...
economist Robert Lucas
Robert Lucas, Jr.
Robert Emerson Lucas, Jr. is an American economist at the University of Chicago. He received the Nobel Prize in Economics in 1995 and is consistently indexed among the top 10 economists in the Research Papers in Economics rankings. He is married to economist Nancy Stokey.He received his B.A. in...
. The model states that economic output is a function of "money" or "price surprise." The model accounts for the empirically based trade off between output and prices represented by the Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...
, but the function breaks from the Phillips curve since only unanticipated price level changes lead to changes in output. The model accounts for empirically observed short-run correlations between output and prices, but maintains the neutrality of money
Neutrality of money
Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption....
(the absence of a price or money supply relationship with output and employment) in the long-run. The policy ineffectiveness proposition
Policy Ineffectiveness Proposition
The Policy Ineffectiveness Proposition is a new classical theory proposed in 1976 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations...
extends the model by arguing that, since people with rational expectations
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...
cannot be systematically surprised by monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
, monetary policy cannot be used to systematically influence the economy.
Background
New classical made its first attempt to model aggregate supply in Lucas and Leonard RappingLeonard Rapping
Leonard Rapping was an economist, most famous for his work with Robert E. Lucas which laid the foundations for real business cycle theory. Although the implications of this work supported laissez-faire policies, Rapping's ideas subsequently evolved in a radical direction. He was highly critical of...
(1969). In this earlier model, supply (specifically labor supply) is a direct function of real wages: More work will be done when real wages are high and less when they are low. Under this model, unemployment is "voluntary." In 1972 Lucas made a second attempt at modelling aggregate demand. This attempt drew from Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...
's natural rate hypothesis that challenged the Phillips curve. Lucas supported his original, theoretical paper that outlined the surprise based supply curve with an empirical paper that demonstrated that countries with a history of stable price levels exhibit larger effects in response to monetary policy than countries where prices have been volatile.
Lucas's model dominated new classical economic business cycle theory until 1982 when real business cycle theory
Real business cycle theory
Real business cycle theory are a class of macroeconomic models in which business cycle fluctuations to a large extent can be accounted for by real shocks. Unlike other leading theories of the business cycle, RBC theory sees recessions and periods of economic growth as the efficient response to...
replaced Lucas's theory of a money driven business cycle with a strictly supply based model that used technology and other real shocks to explain fluctuations in output.
Theory
The rationale behind Lucas's supply theory centers on how suppliers get information. Lucas claimed that suppliers had to respond to a "signal extration" problem when making decisions based on prices; the firms had to determine what portion of price changes in their respective industries reflected a general change in nominal prices (inflation) and what portion reflected a change in real prices for inputs and outputs. Lucas hypothesized that suppliers know their own industries better than the general economy. Given this imbalance in information, a supplier could perceive a general increase in prices due to inflation as an increase the relative priceRelative price
A relative price is the price of a commodity such as a good or service in terms of another; i.e., the ratio of two prices. A relative price may be expressed in terms of a ratio between any two prices or the ratio between the price of one particular good and a weighted average of all other goods...
for its output, reflecting a better, real price for its output and encouraging more production. The surprise leads to an increase in production and employment throughout the economy.
The function can be represented simply as:
The simple version models aggregate output as a function of the price surprise. A more complicated expression of the Lucas supply curve adds expectations to the model. Aggregate supply is a function of the natural rate of output(
) and the difference between actual prices () and the expected price level given past information times a coefficient based on an economy's sensitivity to price surprises ():By invoking Okun's law
Okun's law
In economics, Okun's law is an empirically observed relationship relating unemployment to losses in a country's production first quantified by Arthur M. Okun. The "gap version" states that for every 1% increase in the unemployment rate, a country's GDP will be at an additional roughly 2% lower...
to express the function in terms of unemployment, Lucas's supply function can be viewed as an expression of the expectations-augmented Phillips curve.