Everything about The Lucas Critique totally explained
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'd 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.
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