Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

growth: Economies need to get better at turning inputs into goods and services that people want.


Robert Lucas (born 1937)

Bob Lucas led a massive sea change in macroeconomics called the rational expectations revolution. Essentially, Lucas and his colleagues argued that much of the earlier Keynesian macroeconomics (see the earlier ‘John Maynard Keynes’ section) was misleading, because it doesn’t explicitly take into account how people form expectations. If people create their expectations in a forward-looking and rational way, policy makers shouldn’t be able consistently to fool them.

For example, the original Phillips curve relationship (see Chapter 9) suggested that policy makers could ‘buy’ low unemployment at the cost of high inflation. But for this policy to work consistently, it would require people to be consistently fooled: they’d have always to believe that inflation would be low and always be surprised when it turned out to be high!


Edward Prescott (born 1940)

Ed Prescott (along with his colleague Finn Kydland) ran with the whole rational expectations revolution (see the preceding section) and built on it in two important ways:

In general, governments deciding on future policy have a credibility


problem: That is, rational individuals understand that the policy announced today may in fact not be implemented in the future if the government gets a chance to ‘cheat’ and change its plans. Thus they don’t believe the announcement, and the failure of the government to change people’s expectations leads to a worse outcome (for everyone) than if the government was able credibly to commit to a policy. In their 1977 article, ‘Rules Rather than Discretion: The Inconsistency of Optimal Plans’, Kydland and Prescott argue that if policy makers follow rules rather than discretion, they can overcome this commitment problem.


Fluctuations in output in an economy with fully flexible prices can be explained as the economy responding optimally to technology shocks:

In other words, output isn’t deviating from its natural rate, the natural rate itself is constantly varying. Thus, government intervention to smooth the business cycle is misguided.

Kydland and Prescott’s research agenda led to real business cycle (RBC) models. These models stress the importance of rational expectations and microfoundations: the agents (individuals and firms) in the model must be optimising.