Macroeconomics Presentation

Week 11: Question 1 Harley Comrie 17376361

Explain how the Lucas Islands model allows us to generate cyclical fluctuations even in the presence of rational agents

Rational Agents

Rational Agents Rational agents have rational expectations

Rational expectations are based on optimal forecasting, developed using all available information

They act in response to these expectations, and this minimises business cycle fluctuations

Wouldnt that mean they should always be able to predict the market which would minimise business cycle fluctuations?

Rational Agents

Not entirely, as the predictions have errors

Errors in predicted expectations are caused by information shocks, as the original predictions were made by assuming the information

P=P*+ [E]P=P*

Lucas Islands Model

Lucas Islands Model

The Lucas Islands Model further explains information shocks and the errors they cause in the economic predictions of rational agents.

It demonstrates the signal extraction problem, and underlines the importance of economic information in determining economic outcomes.

Lucas Islands Model Lucas asks us to imagine

the economy as a set of islands, in which different markets operate individually and as part of a greater economy

Information is localized in these islands, and they do not have a perfect understanding of the economic positions of each other.

Lucas Islands Model Wages for labour are relative, if an islands wage increases

at a rate lower than other islands, and then their real wage may have not actually increased.

If labor faces an increase in real wages they may choose to substitute more labor due to the increased opportunity cost of their leisure time.

This is called inter-temporal substitution of labour.

If real wages have not actually increased, they would not choose to do this, as there would be no opportunity cost change.

Lucas Islands Modelyz yz* = (pz Ez p)pz = p + uzp = Ep + uppz = Ep + up + uz

Supply Function

Price

Substitute Price

Ez p = pz + (1 )Ep

= p2

p2 + z

2

Expected Price

Theta

Signal Extraction When the market shows increase in price, we cannot know if it is

relative to the economy. We cannot extract the correct signal.

We dont know whether to raise output to take advantage or to leave it alone.

The theta demonstrates the average price rise, if it is small then it is price stable and thus we should rise output, if large then we should not. This still does not tell us for sure that this instance will not effect the overall economy.

This uncertainty demonstrates that despite the expectations of rational agents, the forecasting still suffers from information shocks.

Effects Due to the uncertainty of

markets to as whether an increase is market or economy wide, there is likely to be an upward sloping SRAS curve as when prices go up they are likely to increase output

This depends on the variance of the markets prices compared to the economy

Monetary Policy Intervention Monetary policy

could cause a demand increase.

This would steepen the SRAS however, and have diminishing effects

Business cycle fluctuates

Conclusion The Lucas Islands model allows us to generate cyclical

fluctuations even in the presence of rational agents.

The Islands model demonstrates the problem of signal extraction

Signal extraction issues cause errors in the economic forecasts that form the rational expectations of rational agents

These errors result in the anticipated actions of agents being incorrect, and thus the business cycle fluctuates

Thank you for listening!