Kydland and Edward C. Prescott, replaced Lucas's theory of a money driven business cycle with a strictly supply based model that used technology and other real shocks to explain fluctuations in output. Theory The rationale behind Lucas's supply theory centers on how suppliers get information. Lucas claimed that suppliers had to respond to a "signal extraction" problem when making decisions based on prices; the firms had to determine what portion of price changes in their respective industries reflected a general change in nominal prices (inflation) and what portion reflected a change in real prices for inputs and outputs. Lucas hypothesized that suppliers know their own industries better than the general economy. Given this imbalance in information, a supplier could perceive a general increase in prices due to inflation as an increase the relative price for its output, reflecting a better, real price for its output and encouraging more production. The surprise leads to an increase in production and employment throughout the economy. The function can be represented simply as: The simple version models aggregate output as a function of the price surprise. A more complicated expression of the Lucas supply curve adds expectations to the model. Aggregate supply is a function of the “natural” level of output () and the difference between actual prices () and the expected price level given past information times a coefficient based on an economy's sensitivity to price surprises (): By invoking Okun's law to express the function in terms of unemployment, Lucas's supply function can be viewed as an expression of the expectations-augmented Phillips curve. See also Lucas islands model References Further reading New classical macroeconomics