In an extremely influential 1976 article, American economist Robert E. Lucas Jr. questioned the ability of econometric models to predict the effect of policy experiments. According to Lucas, reduced-form econometric models are not able to provide useful information about the outcomes of alternative policies because the structure of the economy changes when policy changes.
Lucas describes the economy in time, t, by a vector yt of state variables, a vector xt of exogenous forcing variables, and a vector εt of independent and identically distributed random shocks. One estimates the values of a fixed parameter vector θ, with the F function of behavioral relationships suggested by economic theory:
With knowledge of F and θ, policy evaluation becomes straightforward. However, F and θ derive from (optimal) decision rules of the economy. It is the central assumption that once F and θ are approximately known, they will remain stable under arbitrary changes in the behavior of xt. To assume stability of (F, θ ) under alternative policy rules is to assume that agents’ views about the behavior of shocks to the system are invariant under changes in the true behavior of these shocks. The empirical implication is that the estimated vector θ is not invariant but will change with policy interventions, which invalidates forecasts and policy predictions. Under (1), Lucas (1976) discusses in turn the aggregate consumption function, the investment function (reconsidered in Oliner et al. 1996), and the popular Phillips curves of the 1970s.
The reaction to the Lucas critique has been to formulate dynamic macromodels with rational expectations and optimizing foundations. Empirical evidence has suggested that price and real variables exhibit gradual responses to shocks. Given that forward-looking specifications with those desirable foundations do not replicate features from the data, reconsiderations have followed, such as Arturo Estrella and Jeffrey Fuhrer (2002) in macromodels and George Evans and Garey Ramey (2006) under adaptive expectations.
Other studies have delved into the framework in (1). Jesper Lindé (2001) examines money demand (MD) and consumption functions (CF) to see whether the θ -parameters are dependent on the monetary policy Taylor-rule (TR). There are two sets of observations [1, 2,…, T/2; and (T/2) + 1,…, T] under the assumption that TR changes unexpectedly after T/2 periods from one monetary policy regime to another. See also Richard Clarida et al. (2000) on shifting monetary policies at the U.S. Federal Reserve.
Estimating parameter vectors for all functions in both subperiods (θ 1 and θ 2), Lindé employs breakpoint tests to see whether the null hypothesis of equal parameters is rejected and concludes that the Lucas critique is quantitatively important in a statistical sense. It remains to be seen whether changes in the θ -parameters are sufficiently large to cast doubt on forecasting exercises. The methodology then tests, according to the Lucas critique, whether the null is false. If the computed probabilities of rejecting parameter stability in MD and TR at the same time are low, the power of the test (defined as 1 – β, where β is the type-II error or the probability of not rejecting H 0 given that H 0 is false) is low in small samples. Simulations in Lindé suggest this is indeed the case, although the tests are given the best possible environment for detecting regime shifts. This implies that the methodology used is not capable of detecting the relevance of the Lucas critique in small samples. This negative finding suggests further work along these lines seems warranted.
SEE ALSO Economics, New Classical; Expectations; Expectations, Rational; Lucas, Robert E., Jr.; Policy, Fiscal; Policy, Monetary
Clarida, Richard, Jordi Gali, and Mark Gertler. 2000. Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory. Quarterly Journal of Economics 115: 147–180.
Estrella, Arturo, and Jeffrey Fuhrer. 2002. Dynamic Inconsistencies: Counterfactual Implications of a Class of Rational Expectations Models. American Economic Review 92 (4): 1013–1028.
Evans, George, and Garey Ramey. 2006. Adaptive Expectations, Underparametrization, and the Lucas Critique. Journal of Monetary Economics 53 (2): 249–264.
Lindé, Jesper. 2001. Testing for the Lucas Critique: A Quantitative Investigation. American Economic Review 91:986–1005.
Lucas, Robert E., Jr. 1976. Econometric Policy Evaluation: A Critique. Carnegie-Rochester Conferences in Public Policy 1: 19–46. Supplemental Series to the Journal of Monetary Economics.
Oliner, Stephen, Glenn Rudebusch, and Daniel Sichel. 1996. The Lucas Critique Revisited: Assessing the Stability of Empirical Euler Equations for Investment. Journal of Econometrics 70: 291–316.
Andre V. Mollick