The Rational Expectations School

If Keynes' General Theory was a paradigmatic break with the neoclassical mainstream of the profession, bringing down established orthodoxy, then Robert Lucas' famous paper "Expectations and the Neutrality of Money" was the final restoration after the monetarist assault on Keynesian economics. The previous chapter discussed the rise of monetarism, and showed that while the policy conclusions of monetarist authors were frequently at odds with those of Keynesian authors, they were content to operate within a shared model, one that allowed policy to regularly exercise real effects, at least within the short run. Friedman's framework had essentially accepted the Neoclassical Synthesis version of Keynesian ideas, with the ISLM and the Phillips Curve, with the addition of the notion of a natural rate of unemployment, as the basis for his analysis. Lucas would ultimately reject these terms of engagement. For him, rational maximizing of individual behavior was the quintessential insight that economic theory had to offer, from which all analysis and conclusions should follow. Without it, macroeconomics was little more than unstructured wishful thinking. Thus, his theoretical model demanded a complete reconstruction of macroeconomics on a microeconomic footing, and the abandonment of Keynes' insights. For Lucas, Keynesian ideas should not be taken too seriously. The notion that macroeconomics should simply involve the aggregation of individual behavior was thereby reintroduced, and would profoundly reshape mainstream macroeconomic analysis. Lucas argued that, apart from problems of information, markets always cleared relatively quickly, and that there was no such thing as involuntary unemployment. If people are unemployed it is simply a result of a rational choice. A reduction in real wages would always produce an increase in employment, everything else constant. If workers are unemployed it is because they decided not to work at the given real wage. No policy other than laissez-faire is necessary. For Lucas, government is not the solution, but part of the problem, as much as it was for Reagan, who would later argue, within the political arena, for the same idea.