The Hidden Lesson in the History of the Lucas Critique
The example that Lucas had most in mind was monetary policy’s effects on employment and real output. What we now call “the great inflation” of the 1960s and 1970s was front of mind in 1976. Today it is viewed as a colossal, persistent policy error. Students learn that the cause of the great inflation was that when our government increased its spending (both to fight the Vietnam War, and to achieve the ambitious domestic agenda of the Great Society objectives) the Federal Reserve accommodated the rising deficits by expanding its purchases of government debt, which produced accelerating inflation.
The Federal Reserve at the time (self-servingly) claimed that it had not caused the inflation. And Fed Chair Arthur Burns (who led the Fed from February 1970 through January 1978) even argued that monetary policy was powerless to end the inflation – a view that led him to advocate price controls to President Richard Nixon. Policy makers also continued to argue that rising unemployment could be addressed with further monetary expansion, and that this could be done without raising the level of inflation.
That thinking was based on the “Phillips Curve” – an empirical regularity documented from past behavior – which suggested that one could forecast the amount of added employment and real GDP they could achieve by expanding the money supply by a given amount.
That mechanical view of the effects of monetary policy ignored that people form expectations by observing government and central bank policies and rely upon those expectations when entering into labor bargains and purchase decisions. Once people learn that higher monetary growth led to higher inflation, the policy implications of the Phillips Curve must change because expansionary monetary policy must become less effective in raising employment and output; people see inflation coming and bid up their own prices accordingly, which offsets the expansionary effect of the policy.
