The Lucas islands model is an

economic model In economics, a model is a theoretical construct representing economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified, often mathematical, framework desi ...

of the link between

money supply In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include Circulation (curren ...

and price and

output Output may refer to: * The information produced by a computer, see Input/output * An output state of a system, see state (computer science) * Output (economics), the amount of goods and services produced ** Gross output in economics, the value ...

changes in a simplified economy using

rational expectations In economics, "rational expectations" are model-consistent expectations, in that agents inside the model are assumed to "know the model" and on average take the model's predictions as valid. Rational expectations ensure internal consistency in ...

. It delivered a

new classical 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 founda ...

explanation of the

Phillips curve The Phillips curve is an economic model, named after William Phillips (economist), William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did no ...

relationship between

unemployment Unemployment, according to the OECD (Organisation for Economic Co-operation and Development), is people above a specified age (usually 15) not being in paid employment or self-employment but currently available for work during the refer ...

and

inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...

. The model was formulated by

Robert Lucas, Jr. Robert Emerson Lucas Jr. (born September 15, 1937) is an American economist at the University of Chicago, where he is currently the John Dewey Distinguished Service Professor Emeritus in Economics and the College. Widely regarded as the central ...

in a series of papers in the 1970s.

Description

The model contains a group of N islands, with one individual on each. Each individual produces some quantity Y, which can be bought for some amount of money M. Individuals use money a given number of times to buy a certain quantity of goods which cost a certain price. In the

quantity theory of money In monetary economics, the quantity theory of money (often abbreviated QTM) is one of the directions of Western economic thought that emerged in the 16th-17th centuries. The QTM states that the general price level of goods and services is directl ...

, this is expressed as MV = PY, where money supply times velocity equals price times output. Lucas then introduced variation in the price level. This can occur through changes in the local price level of individual islands due to increased or decreased demand (i.e. asymmetric preferences, z) or through

stochastic processes In probability theory and related fields, a stochastic () or random process is a mathematical object usually defined as a family of random variables. Stochastic processes are widely used as mathematical models of systems and phenomena that a ...

(randomness) that cannot be predicted (e). However, the island dweller only observes the

nominal Nominal may refer to: Linguistics and grammar * Nominal (linguistics), one of the parts of speech * Nominal, the adjectival form of "noun", as in "nominal agreement" (= "noun agreement") * Nominal sentence, a sentence without a finite verb * Nou ...

price change, not the component price changes. Essentially, all prices can be rising, in which case the islander wants to produce the same, as his real income is the same, which is shown by (e). Or the price of his product is rising and others are not, which is z, in which case he wants to increase supply due to a higher price. The islander wishes to respond to z but not to e, but since he can only see the total price change p (p = z + e), he makes errors. Due to this, if the money supply is expanded, causing general inflation, he will increase production even though he is not receiving as high of a price as he thinks (he confuses some of the price as an increase in z). This exhibits a

relationship, as inflation is positively related with output (i.e. inflation is negatively related with unemployment). However, and this is the point, the existence of a short-run Phillips curve does not make the central bank capable of exploiting this relationship in a systematic way. Although economic agents are expected to respond to changes in the price level, the central bank is not able to control the real economy. Since erratic changes may occur in the macroeconomic environment (interpreted as white noises) and agents are assumed to be fully rational, controlling the real economy (unemployment and production) is possible only through surprises (or, in other words, unexpected monetary policy actions) which, however, cannot be systematic. The twist is that due to the

included in the model, the islander isn't tricked by long-run

, as he incorporates this into his predictions and correctly identifies this as pi (long-run

trend A fad or trend is any form of collective behavior that develops within a culture, a generation or social group in which a group of people enthusiastically follow an impulse for a short period. Fads are objects or behaviors that achieve short- ...

inflation) and not z. This is essentially the

policy ineffectiveness proposition The policy-ineffectiveness proposition (PIP) is a new classical theory proposed in 1975 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations, which posits that monetary policy cannot systematically manage the levels ...

. This means in the long-run, inflation cannot induce increases in output, which means the Phillips curve is vertical. An important consequence of the Lucas islands model is that it requires that we distinguish between anticipated and unanticipated changes in monetary policy. If changes in monetary policy and the resulting changes in inflation are anticipated, then the islanders are not misled by any price changes that they observe. Consequently, they will not adjust production and the

neutrality of money Neutral or neutrality may refer to: Mathematics and natural science Biology * Neutral organisms, in ecology, those that obey the unified neutral theory of biodiversity Chemistry and physics * Neutralization (chemistry), a chemical reaction ...

occurs even in the short-run. With unanticipated changes in inflation, the islanders face the imperfect information problem and will adjust production. Therefore, monetary policy can influence output only as long as it surprises individuals and firms in an economy.

References

External links

* {{Macroeconomics Monetary economics Monetary policy New classical macroeconomics

Description

See also

References

Further reading

External links