Interest Rates and Inflation

Reconciling the consensus view that raising short rates fights inflation with the quantity-theoretic evidence that inflation and interest rates move together with money growth in the long run, this paper builds a segmented-markets exchange economy that can do both. In the model, all agents share the same preferences and constant endowment, but only a fraction λ (“traders”) participate in the bond market where open-market operations occur, while “non-traders” never do; this segmentation, adapted from Grossman-Weiss/Rotemberg-style models, generates a genuine short-run liquidity effect – an open-market bond purchase lowers the nominal interest rate by an amount proportional to a coefficient φ that depends on the degree of segmentation – while the underlying equation of exchange still ties long-run inflation to money growth exactly as the quantity theory predicts. Introducing velocity shocks and working through a sequence of policy examples, the paper shows that a money-growth rule that can be conditioned on the contemporaneous velocity shock can hit an announced inflation target exactly, for any shock process, whereas Taylor-type interest-rate feedback rules, though they use exactly the same information, generically cannot do as well: because they tie the interest rate to a base rate determined by long-run (Fisherian) considerations outside the policymaker’s control, “committing to a Taylor rule amounts to tying the hands of the monetary authority in a way that can only limit its effectiveness” at controlling inflation. The paper’s headline conclusion is a “qualified affirmative answer” to whether interest-rate policy can be rationalized within an essentially quantity-theoretic framework: yes, once markets are segmented enough to generate a liquidity effect, but the specific practice of following a Taylor rule for inflation control alone cannot be justified as better than direct money-growth management, and must instead be rationalized by some other policy objective, such as smoothing real interest rates in the presence of endowment risk that segmented markets prevent agents from pooling.

Methods and Problems in Business Cycle Theory

This 1980 essay by Robert Lucas, prepared for an American Enterprise Institute seminar on rational expectations, opens by proposing that economic theories be understood not as claims about how actual economies behave but as explicit instructions for constructing fully articulated, artificial “analogue” model economies whose behavior can be tested against data and against each other, so that a genuinely useful model will necessarily be abstract and unrealistic on its face. From this vantage point, Lucas retraces the history of business cycle theory: Wesley Mitchell’s early twentieth-century statistical documentation of recurring co-movements among economic series; Keynes’s Treatise on Money and General Theory, which Lucas reads as intelligent but technically under-equipped attempts to combine a quantity-theoretic view of nominal prices with real-side determination of output; and the postwar “neoclassical synthesis” of Samuelson, Hicks, Modigliani, and Patinkin, which grafted a Samuelson-style theory of disequilibrium price dynamics – prices and quantities adjusting toward a static general-equilibrium core in response to “excess demands” – onto that equilibrium core, gaining its ability to mimic Keynesian business cycles from added free parameters governing the speed of that adjustment. Lucas argues this synthesis was disturbed from the late 1960s by Milton Friedman’s natural-rate hypothesis and Edmund Phelps’s search for microeconomic foundations of wage and price setting, both of which implied no long-run trade-off between inflation and unemployment, and that John Muth’s rational-expectations hypothesis subsequently proved essential, and subversive, once economists tried to formalize how expectations should be modeled under that hypothesis. In parallel, Lucas traces a purely technical development in general equilibrium theory – Hicks’s reinterpretation of dynamic choice as choice over dated goods, and Arrow and Debreu’s further extension of commodities to be indexed by the state of nature in which they are delivered – which let uncertainty be incorporated into competitive equilibrium theory without any disequilibrium-adjustment apparatus, and which underlies both rational expectations and a new class of “equilibrium models of the business cycle” that treat prices and quantities as always market-clearing. Using an extended example contrasting the unpredictability of an isolated animal’s behavior with the predictability that competitive interaction restores to group outcomes, Lucas argues that competitive-equilibrium models of wage and employment determination can in principle match the fit of Phillips-curve-style models while relying only on parameters describing preferences and technology, rather than an added, empirically opaque parameter describing the speed of an auctioneer’s wage adjustment. He concludes that the discipline’s task is to build policy-evaluation model economies whose deep parameters are estimated from individual and cross-sectional behavior rather than fitted to aggregate time series, and that this is best understood as a continuation, not a rejection, of the same practical compromise between ambition and available technique that produced the neoclassical synthesis itself.

Robert E. Lucas | Macro Paper Warehouse

Interest Rates and Inflation

Methods and Problems in Business Cycle Theory