Lucas_critique

The Lucas Critique, named for Robert Lucas\'s work on macroeconomic policymaking, says that it\'s naive to try to predict the effect of a policy experiment based purely on correlations in historical data, especially high-level aggregated historical data.

The basic idea pre-dates Lucas\'s contribution, but in a 1976 paper he drove the point home that this simple notion invalidated policy advice conditioned on the response of estimated system of equation models. Because the parameters of those models were not structural – that is, not policy-invariant – they would necessarily change whenever policy – the rules of the game – was changed. Any policy advice would then be potentially misleading. This argument called into question the prevailing large-scale econometric models that lacked foundations in dynamic economic theory.

The Lucas Critique implies that if we want to predict the effect of a policy experiment, we must model the "deep parameters" (preferences, technology and resource constraints) that govern individual behavior. We can then predict what individuals will do conditional on the change in policy, and add up individual behaviors to calculate the macroeconomic outcome.

The Lucas Critique was influential not only in casting doubt on many models of the economy but also in encouraging macroeconomists to build microfoundations for their models. Microfoundations had always been thought to be desirable; Lucas convinced many economists they were essential. Later Finn Kydland and Edward Prescott pioneered the use of microfoundations to formulate macroeconomic models.

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.

For another (simpler) example, note that Fort Knox has never been robbed. However, this doesn\'t mean we can safely eliminate the guards, since the incentive (not) to rob Fort Knox depends on the presence of the guards.

Further reading

• Lucas, Robert (1976). "Econometric Policy Evaluation: A Critique." Carnegie-Rochester Conference Series on Public Policy 1: 19–46.

See also

• Dynamic inconsistency
• Real business cycles
• Policy Ineffectiveness Proposition
• Goodhart\'s Law
• Rational Expectations
• Model (macroeconomics)
• Dynamic stochastic general equilibrium
• Lucas-Islands model

This article is licensed under the GNU Free Documentation License. It uses material from Wikipedia