03 May 2017

How Does Lucas Differ From Traditional Keynesian Stories on “Money Illusion”?

Economics 11 Comments

I sent an email to an expert but thought I’d also post my issue here:

For a paper I’m doing, I had to go back and re-read Lucas’ 1972 JET paper on the neutrality of money.
In it, he stresses that the agents in his model do not suffer from money illusion. He clarifies what this means in his conclusion:
“This paper has been at attempt to resolve the paradox [that money is a fluttering veil]. The resolution has been effected by postulating economic agents free of money illusion, so that the Ricardian hypothetical experiment of a fully announced, proportional monetary expansion will have no real consequences (that is, so that money is a veil). These rational agents are then placed in a setting in which the information conveyed by market prices…”
So here’s my question: In what sense do the traditional workers in a Keynesian theory behave differently from Lucas’ agents?
In the standard explanation, I think economists say something like: “The government can run the printing press and this allows employers to offer higher money wages to workers. At first the workers think they are earning a higher *real* wage rate; they think they are going to take those higher money balances and buy more real goods and services in the market place in the future. But when they get to store, they realize prices are higher than they expected. They regret having sold so much of their leisure time for money, because they didn’t realize that the high money wages was simply due to the monetary expansion.”
So, isn’t that exactly what happens in Lucas’ 1972 model? The young people see a high amount of money offered by the old people for their product, and so the young people decide to work more (selling more units of present leisure for what they think will be more units of future consumption). But then when 1 period passes and they become old, these people see higher prices than they expected. They regret having worked so much in the previous period, even though they made the ‘right decision’ at that time, based on the information they had.
Aren’t these compatible stories?

11 Responses to “How Does Lucas Differ From Traditional Keynesian Stories on “Money Illusion”?”

  1. Major-Freedom says:

    Another question is “In what sense does inflation work as ‘fully announced and proportional'”?

  2. Daniel Kuehn says:

    What Lucas adds is rational expectations right? With money illusion under Friedman it’s a “fool me once…” thing. With Lucas agents always have rational expectations so money is neutral in the long run because agents are correct in expectation, not because they change their calculations. They are never tricked in the short run, in other words, there’s just random error and the response to that error generates a Phillips Curve. In the long run the error averages out to zero.

    It’s the core of the difference between New Classical and everything that came before it: he replaced adaptive expectations with rational expectations.

  3. Daniel Kuehn says:

    We were taught that the contribution of Lucas wasn’t to show this short-run/long-run difference which as you say seems pretty similar superficially to money illusion. It was to show that you didn’t need anything going on on the demand side to get an empirical short run Phillips Curve. It was “New Classical” precisely because everything was happening on the supply side again and there was nothing having to do with demand that you had to invoke to get the short-run behavior associated with the Phillips Curve.

    To get this you needed RE. Then New Keynesians came along and said “fine we’ll keep your RE and show if you make things more reasonable on other dimensions aggregate demand becomes important again.

    • Bob Murphy says:

      Daniel thank you for your replies. I agree with everything you say; I was taught similar things.

      But as I’m thinking about it more, I don’t see that there’s that big of a gulf between the two positions. Look at the following statements and tell me if you see what I mean.

      (A) Keynesians/Friedman talking about workers: “They incorrectly thought a boost in money wage rates was a real wage increase, because they didn’t know as much as economists.”

      (B) Lucas talking about workers: “They incorrectly thought a boost in money wage rates was a real wage increase, because they lacked perfect information.”

      • Daniel Kuehn says:

        Right I agree – insofar as they’re both incorrect in the short run it’s exactly the same. Both have a short-run Phillips Curve and no long-run Phillips Curve.

        If the adaptive/rational expectations difference isn’t that big of a gulf the other big difference is that Lucas is all on the supply side (producers responding to prices) while Friedman and the Keynesians are all on the demand side. That’s the bigger practical gulf.

        • Transformer says:

          ‘Friedman and the Keynesians are all on the demand side”

          But isn’t distorted supply of labor central to the Friedman story ?

  4. Transformer says:

    I think there is a sense in which people suffering from money illusion are acting irrationally. If they only drew the correct implication of changes in the money supply and other indicators they would not make labor supply decisions that they later regret (and that lead to deviations from optimal output levels in the economy).

    While the math is inpenetrable to me I think Lucas claims to have written a model where everyone makes rational decision based on all available information and we still end up with monetary fluctuations leading to real output movements.

    • Bob Murphy says:

      Yes everything you say is right Transformer, but my point is that in Lucas’ model, what happens actually seems very close to money illusion. The workers are making EXACTLY the mistake of the traditional workers who suffer from the illusion, it’s just that we don’t hold it against them because they lacked the relevant information when they made the decision.

      To go the other way, why can’t we exonerate the traditional workers who suffer from money illusion, and say, “Sure they made a mistake, but it was an understandable mistake given their information set.” ?

      • Transformer says:

        Yes, I think the difference may be between workers “lacking the relevant information” and “having the relevant information but misinterpreting it” – but I agree this is very thin line.

  5. Harold says:

    From the introduction:
    “In the particular framework presented
    below, prices convey this information only imperfectly, forcing agents to
    hedge on whether a particular price movement results from a relative
    demand shift or a nominal (monetary) one. This hedging behavior results
    in a nonneutrality of money, or broadly speaking a Phillips curve, similar
    in nature to that which we observe in reality.”

    It is this imperfect conveying of information that seems to be the problem.
    My very uncertain thoughts are that the money illusion and imperfect conveying of information through prices, requiring hedging may be much the same thing?

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