-markets clear and there is nothing systematic that monetary policy can do to affect output or unemployment.
Two key features:
1. It places the weight on rational expectations. Expectations are based on all available information.
2. It insists on equilibrium; there is market clearing.
Full neoclassical theory – unemployment is always at the natural rate, output is always at the full-employment level, and any unemployment is purely frictional. Changes in the price level leave output and unemployment unchanged. Money wages will rise (wages are flexible to changes in price level), but since real wage is unchanged, neither the quantity of labor supplied nor demanded will change.
LUCAS MODEL – some people do not know the aggregate price level but do know the nominal wage or price at which they can buy and sell.
* Anticipated changes – Firms and workers expect the change in price. If both actual and expected prices will change in proportion to the change in money supply, the real money supply will remain unchanged, and the economy will remain at full employment.
* Unanticipated changes – Expected price will not change. For example, if workers do not expect the increase in price, there will be an increase in output.
Lucas model predicts that neither monetary nor fiscal policy can affect the equilibrium level of income in the long run. There might be transitory deviations but they are the result of expectations errors and they last only as long as the errors last which is not very long since households and firms will revise their forecasts.
RANDOM WALK OF GDP
Transitory fluctuations are caused by shocks to aggregate demand while permanent fluctuations are caused by aggregate supply. That is because the supply determines the output.
There is significant empirical evidence that macroeconomic fluctuations are dominated by shocks with permanent effects. Since aggregate demand shocks do not have permanent effects, this evidence...