Lucas critique

Lucas critique
The Lucas critique, named for Robert Lucas' work on macroeconomic policymaking, argues that it is nave 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.[1] The basic idea pre-dates Lucas' contribution (related ideas are expressed as Campbell's Law and Goodhart's Law), but in a 1976 paper Lucas drove home the point that this simple notion invalidated policy advice based on conclusions drawn from large-scale macroeconometric models. Because the parameters of those models were not structural, i.e. not policy-invariant, they would necessarily change whenever policy (the rules of the game) was changed. Policy conclusions based on those models would therefore potentially be misleading. This argument called into question the prevailing large-scale econometric models that lacked foundations in dynamic economic theory. Lucas summarized his critique: "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."[2] The Lucas critique suggests that if we want to predict the effect of a policy experiment, we should model the "deep parameters" (relating to preferences, technology and resource constraints) that govern individual behavior. We can then 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.[3] The Lucas critique was influential not only because it cast doubt on many existing models, but also because it encouraged macroeconomists to build microfoundations for their models. Microfoundations had always been thought to be desirable; Lucas convinced many economists they were essential. Real Business Cycle economists, starting with Finn Kydland and Edward Prescott, focused their research on using microfoundations to formulate macroeconomic models. Contemporary macroeconomic models microfounded on the interaction of rational agents are often called dynamic stochastic general equilibrium (DSGE) models.

Examples
One important application of the critique is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could 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. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes. For an especially simple example, note that Fort Knox has never been robbed. However, this does not mean the guards can safely be eliminated, since the incentive not to rob Fort Knox depends on the presence of the guards. In other words, with 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 for example, 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.

Lucas critique

Citations
[1] Lucas, Robert (1976-01-01). "Econometric policy evaluation: A critique". Carnegie-Rochester Conference Series on Public Policy 1 (1): 19-46. [2] Lucas (1976), p. 41. [3] Lucas (1976), p. 21.

Further reading
Lucas, Robert (1976), "Econometric Policy Evaluation: A Critique", in Brunner, K.; Meltzer, A., The Phillips Curve and Labor Markets, Carnegie-Rochester Conference Series on Public Policy, 1, New York: American Elsevier, pp.1946, ISBN0-444-11007-0 Kydland, Finn E.; Prescott, Edward C. (1977), "Rules Rather Than Discretion: The Inconsistency of Optimal Plans", Journal of Political Economy 85 (3): 473491, doi:10.1086/260580 Tesfatsion, Leigh (2010), Notes on the Lucas Critique, Time Inconsistency, and Related Issues (http://www. econ.iastate.edu/tesfatsi/luccrit.pdf) Sargent, Thomas (1996), "Expectations and the Nonneutrality of Lucas", Journal of Monetary Economics

Article Sources and Contributors

Article Sources and Contributors

Lucas critique Source: http://en.wikipedia.org/w/index.php?oldid=493486175 Contributors: AlexOUK, Bender235, Benuel, Bkwillwm, Bluemoose, Bobo192, Buldri, Byelf2007, Calton, Cfp, Earth, FrankTobia, Iota, Jacob Lundberg, John Quiggin, Johnuser17, Jonkerz, Lawlorg, MaCRoEco, Maurreen, N2e, Nbarth, Ocaasi, Pearle, Pharwood, Phyrrus52, RedHouse18, Rinconsoleao, Robert Avila, Robertson-Glasgow, Rochecon, Ryoutou, Saibo, Tesfatsion, The Land, Volunteer Marek, WpZurp, 48 anonymous edits

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