Lucas's Research in the Late 1960s and the Natural Rate of Unemployment

Abstract

This article describes the work of Robert E. Lucas Jr. in the late 1960s, which culminated in the modeling and testing of the natural rate of unemployment hypothesis. I show the roles played by Edmund Phelps and Edward Prescott in Lucas's transition from adaptive expectations to rational expectations in the modeling and testing of this hypothesis. I argue that Phelps criticized the predominance of the regressive effect in price expectations in Lucas and Rapping's (1969a) labor market model as the explanation to the tradeoff between inflation and unemployment and also introduced Lucas to his island model, which would be eventually adopted by Lucas (1972). I also argue that Prescott helped Lucas in the substitution of the adaptive expectations with the criticized regressive effect hypothesis by the rational expectations hypothesis, by working on its mathematical definition and debating the proper justification for its adoption. Finally, I show how the discussion over the substitution of the adaptive expectations by the rational expectations led Lucas to change his econometric testing of the natural rate of unemployment hypothesis from estimating long-run Phillips curves in a model with adaptive expectations to testing restrictions on the relationship between policy parameters and behavioral parameters of a model with rational expectations.