Lucas critique

Lucas critique

Overview
The Lucas critique, named for Robert Lucas
Robert Lucas, Jr.
Robert Emerson Lucas, Jr. is an American economist at the University of Chicago. He received the Nobel Prize in Economics in 1995 and is consistently indexed among the top 10 economists in the Research Papers in Economics rankings. He is married to economist Nancy Stokey.He received his B.A. in...

′ work on macroeconomic policymaking, argues that it is naïve 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
Aggregate data
In statistics, aggregate data describes data combined from several measurements.In economics, aggregate data or data aggregates describes high-level data that is composed of a multitude or combination of other more individual data....

 historical data.

The basic idea pre-dates Lucas' contribution (related ideas are expressed as Campbell's Law
Campbell's Law
Campbell's law is an adage developed by Donald T. Campbell:The social science principle of Campbell's law is sometimes used to point out the negative consequences of high-stakes testing in U.S...

 and Goodhart's Law
Goodhart's law
Goodhart's law, although it can be expressed in many ways, states that once a social or economic indicator or other surrogate measure is made a target for the purpose of conducting social or economic policy, then it will lose the information content that would qualify it to play that role...

), 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 model
Large-scale macroeconometric model
Following the development of Keynesian economics, applied economics began developing forecasting models based on economic data including national income and product accounting data. In contrast with typical textbook models, these large-scale macroeconometric models used large amounts of data and...

s.
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Encyclopedia
The Lucas critique, named for Robert Lucas
Robert Lucas, Jr.
Robert Emerson Lucas, Jr. is an American economist at the University of Chicago. He received the Nobel Prize in Economics in 1995 and is consistently indexed among the top 10 economists in the Research Papers in Economics rankings. He is married to economist Nancy Stokey.He received his B.A. in...

′ work on macroeconomic policymaking, argues that it is naïve 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
Aggregate data
In statistics, aggregate data describes data combined from several measurements.In economics, aggregate data or data aggregates describes high-level data that is composed of a multitude or combination of other more individual data....

 historical data.

The basic idea pre-dates Lucas' contribution (related ideas are expressed as Campbell's Law
Campbell's Law
Campbell's law is an adage developed by Donald T. Campbell:The social science principle of Campbell's law is sometimes used to point out the negative consequences of high-stakes testing in U.S...

 and Goodhart's Law
Goodhart's law
Goodhart's law, although it can be expressed in many ways, states that once a social or economic indicator or other surrogate measure is made a target for the purpose of conducting social or economic policy, then it will lose the information content that would qualify it to play that role...

), 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 model
Large-scale macroeconometric model
Following the development of Keynesian economics, applied economics began developing forecasting models based on economic data including national income and product accounting data. In contrast with typical textbook models, these large-scale macroeconometric models used large amounts of data and...

s. 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."


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
Production function
In microeconomics and macroeconomics, a production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations of inputs...

 and resource constraints
Budget constraint
A budget constraint represents the combinations of goods and services that a consumer can purchase given current prices with his or her income. Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices...

) 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
Microfoundations
In economics, the term microfoundations refers to the microeconomic analysis of the behavior of individual agents such as households or firms that underpins a macroeconomic theory....

 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
Agent (economics)
In economics, an agent is an actor and decision maker in a model. Typically, every agent makes decisions by solving a well or ill defined optimization/choice problem. The term agent can also be seen as equivalent to player in game theory....

 are often called dynamic stochastic general equilibrium
Dynamic stochastic general equilibrium
Dynamic stochastic general equilibrium modeling is a branch of applied general equilibrium theory that is influential in contemporary macroeconomics...

 (DSGE) models.

Examples


One important application of the critique is its implication that the historical negative correlation between inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

 and unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

, known as the Phillips Curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

, 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
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

 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
United States Bullion Depository
The United States Bullion Depository, often known as Fort Knox, is a fortified vault building located adjacent to Fort Knox, Kentucky, used to store a large portion of United States official gold reserves and occasionally other precious items belonging or entrusted to the federal government.The...

 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.

See also

  • Dynamic inconsistency
    Dynamic inconsistency
    In economics, dynamic inconsistency, or time inconsistency, describes a situation where a decision-maker's preferences change over time in such a way that what is preferred at one point in time is inconsistent with what is preferred at another point in time...

  • Game theory
    Game theory
    Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...

  • Dynamic stochastic general equilibrium
    Dynamic stochastic general equilibrium
    Dynamic stochastic general equilibrium modeling is a branch of applied general equilibrium theory that is influential in contemporary macroeconomics...

  • Real business cycles
  • Policy Ineffectiveness Proposition
    Policy Ineffectiveness Proposition
    The Policy Ineffectiveness Proposition is a new classical theory proposed in 1976 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations...

  • Goodhart's Law
    Goodhart's law
    Goodhart's law, although it can be expressed in many ways, states that once a social or economic indicator or other surrogate measure is made a target for the purpose of conducting social or economic policy, then it will lose the information content that would qualify it to play that role...

  • Campbell's Law
    Campbell's Law
    Campbell's law is an adage developed by Donald T. Campbell:The social science principle of Campbell's law is sometimes used to point out the negative consequences of high-stakes testing in U.S...

  • Rational Expectations
    Rational expectations
    Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...

  • Macroeconomic model
  • Methodological individualism
    Methodological individualism
    Methodological individualism is the theory that social phenomena can only be accurately explained by showing how they result from the intentional states that motivate the individual actors. The idea has been used to criticize historicism, structural functionalism, and the roles of social class,...

  • Problem of induction
    Problem of induction
    The problem of induction is the philosophical question of whether inductive reasoning leads to knowledge. That is, what is the justification for either:...

  • Variable change
  • Hasty generalization
    Hasty generalization
    Hasty generalization is a logical fallacy of faulty generalization by reaching an inductive generalization based on insufficient evidence essentially making a hasty conclusion without considering all of the variables...