Robert Lucas and Real Business-Cycle Theory

In 1978 Robert Lucas and Thomas Sargent launched a famous attack on Keynes and Keynesian economics, which they viewed as having been discredited by the confluence of high inflation and high unemployment in the 1970s. They also expressed optimistism that an equilibrium approach to business-cycle modeling would succeed in replicating reasonably well the observed time-series variables relating to output and employment. In particular they posited that a model subjected to an unexpected monetary shock causing an immediate downturn from an equilibrium time path would be followed by a gradual reversion to that time path, thereby capturing the main stylized facts of historical business cycles. Their optimism was disappointed, because the model that Lucas had developed, based on an informational imperfection preventing agents from distinguishing immediately between real and nominal price changes, could not account for downturns because the informational imperfection assumed by Lucas could not account for the typical…