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Question

Explain the Lucas’ Aggregate Supply Hypothesis. What are the policy implications of this hypothesis when it is considered together with rational expectations hypothesis and continuously clearing markets assumptions? Show by diagrams

Answer 1

Lucas [1973] developed an aggregate supply model that challenged the efficacy of neo-Keynesian macroeconomic stabilization policy and significantly altered the development of macroeconomic models.

Employing a multimarket stochastic equilibrium model, Lucas assumed that individual suppliers decide how much to produce based on perceived relative prices. Their expectations of future prices and demand are formed rationally using all available information about specific and economy-wide prices and quantities. Changes in market specific prices, however, reflect both changes in the general price level and changes in relative prices. Individual suppliers cannot distinguish between the two, because they have instantaneous information about their own specific prices but only lagged information about the general price level.

Thus, a current unanticipated increase in the general price level and nominal aggregate demand will be partly perceived by suppliers as an increase in the relative price and relative demand for their goods, and they will temporarily increase output. A highly volatile general price level and nominal aggregate demand result in less general-relative price confusion and a fading of the short-run output-inflation tradeoff.

That is, the Lucas model suggests an inverse relationship between the output-inflation tradeoff and the variability of the rate of inflation and the rate of change of nominal aggregate demand.

Lucas used a sample of eighteen countries to " ... see whether the terms of the output-inflation `tradeoff' vary across countries in the way predicted by the natural rate theory" [1973, 330]. He estimated the following reduced form supply function over the 1952-67 period:

Empirical studies by Albero [1981], Attfield and Duck [1983], Fernadez [1977], Hanson [1980], Hercowitz [1983] and Koskela and Viren [1980] have generally provided cross-country evidence supporting Luca's variance hypothesis. Froyen and Waud [1980] however, presented, in addition to cross-country evidence, limited intracountry evidence for  the relationship between the output-inflation tradeoff and the variances of the rate of change of nominal income and the price level and  the relationship between the variance of the inflation rate and the variance of the rate of change of nominal income.

They examined these relationships on a cross-country basis for each of ten industrialized countries for the 1956-76 period. The 1957-66 and 1967-76 subperiods were used to make intracountry comparisons in individual countries. Their cross-country and intracountry results support the hypothesis that the output-inflation tradeoff and the variance of the inflation rate are inversely related.

Their evidence, however, does not suggest that the variance of the rate of change of nominal income is negatively correlated with the tradeoff and positively correlated with the variance of the inflation rate.