The Lucas Growth Theory and its Generalization to Business Cycles

The Lucas growth theory (Lucas (1988) has a particular structure that reflects the idea of rational expectations. First there is a situation, in which the households and firms react to what is generally expected to be common knowledge, i.e. a sort of average level of human capital in society. In the theory this level is exogeneously given, just as the exogeneous factor of tech-nological progress in the Solow model. The fundamental equations of the theory are constructed in this situation, which will be here called the ”reaction of the market to common knowledge”. Then market clearing creates a second situation, in which the exogeneously given and the endogeneously produced average levels of human capital coincide. The solution of the fun-damental equations has to take place in the second phase, to be called here the ”market clearing”.