Presentation Speech by Professor Lars E.O. Svensson of the Royal Swedish Academy of Sciences
Translation of the Swedish text
Your Majesties, Your Royal Highnesses, Ladies and Gentlemen,
Robert Lucas is the social scientist who has had the greatest influence on macroeconomic research since 1970. The main objective of macroeconomic research is to study fluctuations in total production, employment and inflation. Lucas’s contributions have transformed macroeconomic analysis and deepened our understanding of economic policy. They have led to a more realistic appreciation of what economic policy can, and cannot, achieve. Lucas has also given us more reliable methods to evaluate the effects of changing economic policy.
A recurrent theme in Lucas’s work is the importance of expectations. Lucas postulated that households, firms and organizations use available information in an efficient way. This hypothesis of rational expectations has had far-reaching consequences for macroeconomic analysis.
The change in our understanding of the Phillips curve is an excellent example of Lucas’s contributions. The Phillips curve, named after its discoverer, a British economist, displays a positive relation between inflation and employment. In the late 1960s, there was considerable empirical support for the Phillips curve; it was regarded as one of the more stable relationships in economics. It was generally interpreted as an option for governments and central banks to bring about a permanent increase in employment by pursuing an expansionary policy that results in more inflation.
However, in an analysis carried out around 1970, Lucas used the concept of rational expectations to demonstrate that employment could definitely not be permanently increased by allowing inflation to rise. Although Lucas was able to explain why the Phillips curve appeared to have so much empirical support, he could also show that any attempt to exploit the Phillips curve and permanently increase employment by systematically creating higher inflation would be futile. According to Lucas’s analysis, the Phillips curve would not remain stable; it would shift when expectations adjusted to higher rates of inflation.
This was not merely an academic subtlety, as was soon demonstrated in practice. During the 1970s governments and central banks in many countries allowed inflation to soar, in order to achieve high employment. In accordance with the theory, there was no sustained increase in employment; the Phillips curve shifted, as Lucas had predicted.
This gives rise to two important policy conclusions. The first is that there are no permanent gains to society from high inflation. On the contrary, high inflation has sustained drawbacks. By now, this conclusion is generally accepted and has become the foundation for the monetary policy pursued in several countries, including Sweden, which aim at achieving low and stable inflation. The second conclusion is that high unemployment and low employment can be successfully remedied only by other means than inflationary monetary and fiscal policy, for instance by structural measures to make the labor market and wage formation function more efficiently.
The fate of the Phillips curve demonstrates the dangers in uncritically using a statistical relationship to draw economic-policy conclusions. The insights into these dangers were developed further in the so-called Lucas Critique. Lucas showed that not only the Phillips curve, but several other significant relationships that had previously been considered stable (for instance, the dependence of consumption and investments on wages, interest rates and taxes) on closer examination are likely to change due to shifts in economic policy. Hence, economic-policy conclusions based on these relationships are not reliable.
But Lucas was not content with these negative implications. Instead, he proposed new theoretical and statistical methods that avoid these pitfalls and can serve as the foundation for more reliable evaluation of the consequences of altering economic policy. Nowadays, these are commonly accepted methods which are used regularly in analysis of economic policy. In addition to his work in macroeconomics, Lucas has made outstanding contributions to several other research fields than macroeconomics, such as monetary theory, financial economics, public economics and economic growth. In each of these fields, Lucas’s work has given research a new direction and generated an extensive new literature.
Dear Professor Lucas,
Your development and application of the theory of rational expectations has fundamentally transformed macroeconomic analysis. It has deepened our understanding of economic policy. Your work has also had a profound impact on research in several other fields of economics. It is a privilege and an honor to convey to you my warmest congratulations, on behalf of the Royal Swedish Academy of Sciences. Please step forward to receive the Prize from His Majesty the King.