Lucas critique

The Lucas Critique, named for Robert Lucas's work on macroeconomic policymaking, says 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.

The basic idea pre-dates Lucas's contribution, but in a 1976 paper he drove home the point that this simple notion invalidated policy advice based on conclusions drawn from 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. 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.

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.

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. Later Finn Kydland and Edward Prescott pioneered the use of 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.

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, like 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. Likewise, 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.

Further reading

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

ee also

*Dynamic inconsistency
*Real business cycles
*Policy Ineffectiveness Proposition
*Goodhart's Law
*Rational Expectations
*Model (macroeconomics)
*Methodological individualism