Lucas Island Model - Applications of The Model

Applications of The Model

Lucas Model (1972) is also a type of an Overlapping generations model (OLG model) where trading is assumed to take place with rational expectations. The OLG model assumption facilitates an endogenous demand for money. The old who can neither store the goods that they produced when they were young nor produce goods when old, are found to pay the young ones for goods. Equilibrium in the market is reached when the old exchange the goods for money with the young. Every period will have its unique equilibrium level. If the money supply is constant and evenly distributed among the old, the price level is assumed to be constant i.e. when everyone is perfectly informed, the price level and the money supply will be proportional. When there is perfect information, a once and for all increase in the money supply will lead to a proportional increase in the price level and employment and production are untouched.
When imperfections are introduced while revealing the money stock to both the agents(the old and the young), price rigidity can occur. Price rigidity is the proposition that some prices adjust slowly in response to market shortages or surpluses. Limiting information is possible when trading occurs in separate markets. The suppliers are not aware owing to the lack of information whether the increase in prices in any one market is caused by the general increase in price level (i.e. inflation) or that there are fewer suppliers in the market which has driven price upwards. Thereby they are faced with a signal extraction problem, the solution to which is to increase the supply when price rises but by an amount that is less than an increase in money supply.