In defence of Lucas '72.
Take any macroeconomic model of a market economy with inefficient aggregate fluctuations. In fact, take any economic model where something bad might happen.
Assume that model is literally true.
The people in that model are idiots.
This conclusion follows immediately. If they weren't idiots, the people in the model would appoint the economist modelling the economy as central planner, who would tell them all what to do, and make them all better off.
The people in Lucas' '72 model are complete idiots for producing less because they don't realise there's a recession on.
The people in New Keynesian models are complete idiots for waiting for the Calvo fairy to give them permission to cut prices in a recession.
All models suffer this same problem. If the world really were as simple as the economic model of that world, people would figure it out, and wouldn't let bad things happen.
It's unfair to single out Lucas '72 for this criticism. Actually, it's doubly unfair, because Lucas did at least address this question, and carefully rigged up the assumptions of his model so that the people in it wouldn't be able to figure out that there's a recession on. Was that a satisfactory answer? Not really, because most people do read the news, and know there's a recession on. But at least Lucas gave an answer.
The map is not the territory. All models are simplifications of reality. They leave masses of stuff out. That's what makes them models. That's what makes them (potentially) useful. But it's also what makes any model of a market economy self-contradictory. If the economy really were that simple, people wouldn't need markets to resolve the Hayekian problem of the coordination of the changing plans of multiple people, each with their own local knowledge.
All real world markets, even the simplest, are more complicated than any economic model of a market.
Take the housing market for example. If I wanted to model it, especially in a macroeconomic model where all complications get squared or cubed when we add them all together, I would use something like a simple demand and supply model. But at the same time I would know that's hopelessly oversimplified.
Suppose you decide to sell your house. You know that your house is different from other houses on hundreds of dimensions that might matter to a potential buyer. You also know that each potential buyer is different, and evaluates each of those dimensions differently from any other buyer. When you post a price, and when you decide whether to accept an offer, or make a counteroffer, you know you face a trade-off between getting a quick sale and waiting for a better price. And each potential buyer faces a trade-off between buying your house now or waiting for a better price or a house that suits him better. And the trade-off facing one seller, and the trade-off facing one buyer, depend on the choices that will be made in future by all the other potential buyers and sellers, which depend in turn on their perceived trade-offs.
That's an incredibly complex market. And I'm sure I've left a load of stuff out.
The labour market is even more complex than the housing market. All that matters to the person selling a house is the price and when he sells it. (OK, that's an oversimplification). The person selling his labour has to think about where he will be spending half his waking hours for the next few years, or decades. And I'm sure I've left a load of other differences out too.
Start in equilibrium (whatever that means in a housing market like I've just described). Now imagine that there's a tightening of monetary policy. What happens?
"God only knows" is the short answer.
Look, monetary economists can't even agree on what "monetary tightening" means. How do you expect the average home seller or buyer to understand it, even if they do all read the newspapers?
In a very simple model of the housing market, and if all markets were equally simple, and if everybody understood monetary policy, I know what would happen. The demand curve would shift left; the supply curve would shift right; and the nominal price of houses would drop in proportion to the drop in the money supply.
At least, that's what I think would happen, but I bet some people reading this will already disagree.
And I'm fairly sure, but not 100% sure, that something vaguely similar to this would happen eventually. After all, for any equilibrium there ought to be another equilibrium where all the monetary units are changed but all the things measured in real units are the same. I'm not 100% sure because there might be more than one real equilibrium.
But in a real world housing market, like the one I have sketched above only more complex, where most people don't understand what's going on, and their mistakes will affect the trade-offs facing other buyers and sellers, and so affect their behaviour, which again affects those trade-offs, and leads to more mistakes.....? I don't know what's precisely going to happen. Nor does any other economist. And, more importantly, the buyers and sellers in that housing market, and all the other markets that interact with that market, won't have a clue what's really happening and what their optimal response should be.
The signal-processing problem facing real buyers and sellers in a real market are massively more complex than the signal-processing problem faced by agents in Lucas' model in a perfectly competitive market of a homogeneous good.
"It's taking me longer to sell my house than I thought it would. Am I pricing too high? Did I just get unlucky, and the person who really wants to buy my house and is prepared to pay my price just happens to be coming a little later than normal by sheer chance? Has my trade-off between getting a quick sale and getting a high price gotten flatter or steeper?"
And potential buyers are asking similar questions.
And no economist knows the answer to those questions, so you can't expect the buyers and sellers to.
That's even before you throw in something like menu costs of changing prices.
Suppose recessions lasted 1 week. If they did, I think most economists would have a very different view of Lucas '72. "It takes people 1 week to figure out there's a recession on and how to react? Sounds plausible."
Suppose recessions last 100 weeks. "It takes people 100 weeks to figure out there's a recession on and how to react? Sounds totally implausible."
But maybe real world markets are 100 times more complex than the simple demand and supply model. And maybe the signal-processing problem is 100 times more complex than in that simple model. And maybe it takes people 100 times longer to figure out how to react, when one person's reaction depends on everyone else's reaction. That sounds plausible to me.
We draw a supply and demand curve and point to where the two curves cross. We shift the supply and demand curves and point to where the two new curves cross. The only people who talk about the process of getting from the first point to the second point are: teachers of Economics 1000; Austrian economists.
Maybe it takes time to get from the first point to the second point. Not because people are idiots, in not changing their prices, or not figuring out what's going on and how to react. But because the territory is a lot more complicated than the map.
And it's always going to be hard to build a map of how the territory is more complicated than the map.