Methods and Problems in Business Cycle Theory

Robert E. Lucas, Jr.

Journal of Money, Credit and Banking, Vol. 12, No. 4, Part 2: Rational Expectations. (Nov.,1980), pp. 696-715.

Robert Lucas begins his critique with an observation; the intention behind Business Cycle Theory is to create “models” of reality, rather than actually model reality to mimic it. It is the purposes behind each pursuit that distinguish the usefulness of RBC models, from any discussion derived from actual economic behavior. The purpose of models is to help us understand the mechanism that exist in reality; to confuse this with a purposed aimed at “realism” is to denigrate or ignore the inherent usefulness of RBC models. Lucas complains that “the theory is not being effectively used to help us to see which opinions about the behavior of actual economies are accurate and which are not.” Its not so important to be a “real” interpretation, as it is to be a “better imitation.” The question arises: “what makes a better imitation than mimicking what is real?” and this is the question that Lucas is setting out to answer.

Lucas points to a few key developments that have allowed RBC models to make a contribution. First, is what Lucas calls a “purely technical” development that enlarges our “abilities to construct analogue economies.” He is of course, talking about formalized mathematical models that allow us to investigate situations or cause-effect relations that would otherwise be to costly to observe in “real economies.” Second, Lucas points us to the fact that RBC models are built in response to different question. Unlike the journalist for whom every new story is a phenomenon based on a new theory, RBC models approach the world with unbending, unchanging formalism. This is probably an overstatement, but it illuminates the need and use of formal models in RBC theory. Third, as more economist and mathematicians specialize in the field, it is no wonder that the field requires more specialization to understand and utilize it in itself. This has caused a misunderstanding amongst outside observers, such that historians have attempted to “understand developments of monetary economics in terms entirely internal to the sub-discipline.”

The author spends some time criticizing Keynes, only in the end to show how much “Keynesianism” in all its advancements are indebted to the neo-classical formalized approach to economics. In this context, Lucas continues with the history of RBC theory in the context of general equilibrium theory, a mode of thought that begins, so he contends, with Alfred Marshall. Paul Samuelson advanced the course of finding a neo-classical synthesis with Keynesianism, by supplying the “main ingredients” for a mathematically explicitly theory of general equilibrium; “an artificial system in which households and firms jointly solve explicit ‘static’ maximum problems.” But, as Lucas points out, business cycles are not static. To correct for this, Samuelson included additional “free” parameters that still had an “equilibrium” point to appease the neo-classicals, while maintaining enough parameters to show a wide variety of possible paths coming as a result of an exogenous shock. There was equilibrium with dis-equilibrium; a synthesis.