Rational Expectations and Inflation

Overview


The Lucas Supply Function


The Lucas supply function hypothesizes that changes in output are driven by price level suprises.
{% y_t - y_t^* = \beta(p_t - \mathbb{E}[p_t|I_{t-1}]) + \epsilon_t %}
  • {% y %} - the log of real output
  • {% y^* %} - if the potential value
  • {% p %} - the log of price level
  • {% \mathbb{E}[p_t|I_{t-1}] %} - the expected price level given the information up to time t
(see Blinder chpt 6)


The Lucas supply function was important in introducing the concept of expectations into economic models. That is, expectations of economic variables can be just as important, if not more, to future economic outcomes as the actual values of variables.

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