LUCAS CRITIQUE The Lucas critique named for Robert

LUCAS CRITIQUE

The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking. He argues that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.

"Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models. "

“Deep parameters" • Preferences • Technology • Resource constraints These deep parameters must be used to predict what individuals will do, taking into account the change in policy, and then aggregate the individual decisions to calculate the macroeconomic effects of the policy change.

The Lucas critique was influential because it encouraged macroeconomists to build micro foundations for their models. Micro foundations had always been thought to be desirable; Lucas convinced many economists they were essential.

EXAMPLES

Fort Knox has never been robbed This does not mean the guards can safely be eliminated The incentive not to rob Fort Knox depends on the presence of the guards. The heavy security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely to succeed.

But a change in security policy, such as eliminating the guards, would lead criminals to reappraise the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not mean this should be expected to continue under all possible policies.

PHILIPS CURVE AND LUCAS CRITIQUE The negative correlation between inflation and unemployment, known as the Phillips Curve, Would break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms‘ inflation forecasts to rise, altering their employment decisions.

Just because high inflation was associated with low unemployment under early-twentieth-century monetary policy This does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes