Lucas Island Model

Lucas Island Model

The Lucas Island Model is an economic model formulated by Robert Lucas, Jr. Before Keynes' The General Theory of Employment, Interest and Money was written, many economists were active in the research of business cycles. In the early 1930s Friedrich Hayek introduced the idea that business cycles stems from individuals misperceptions about relative prices. This idea was taken up by Lucas almost forty years later.
The hypothesis that aggregate supply depends on relative prices is central to the new classical explanation of business cycles. The purpose of the model is to establish the link between money supply and price and output changes in a simplified economy using Rational expectations. Lucas sought to explain the short term procyclicality of output and inflation (the “Phillips curve”) while maintaining the neutrality of money assumption.
This particular model appeared in a series of papers in the early 1970s. These papers especially those by Lucas (1972), (1973) and (1975) were enormously influential in illustrating (and popularising) the power of Rational Expectations as a modelling technique. These papers show us how to use simple general equilibrium models to arrive at structural models of economic fluctuations.