8. Should monetary policy be active? THE LUCAS CRITIQUE AND POLICY EVALUATION Robert Lucas famously extended the rational expectations hypothesis to consider whether historical data can inform considerations about proposed policies. His conclusion is damning – that is, if individuals form expectations rationally, then reduced form models ‘provide no useful information as to the actual consequences of alternative economic policies’ (Lucas, 1976: 20, emphasis in original).1 Lucas’s ‘critique’ builds on Muth’s (1961) seminal insight that expectations depend on the structure in which they develop. This structure shapes how today’s economic conditions evolve into tomorrow’s. Hence, if policies change an economy’s structure, then the manner in which maximizers react to policy variables can also change. In this case, policy makers must predict individuals’ reactions under the new regime from data on the old regime – that is, information about how individuals reacted to policy variables before the economy’s structure changed! Insights to the Phillips Curve’s Breakdown To better understand Lucas’s critique, let’s consider how it rationalizes the Phillips Curve’s breakdown. Recall that the Phillips Curve, on its face, evidences the potential for policy makers to trade higher inﬂation for lower unemployment – that is, it suggests that monetary authorities can dampen real ﬂuctuations if they are willing to incur nominal ﬂuctuations. But evidence from which this trade-oﬀ became apparent takes a reduced form – that is, it largely rests on the negative correlation between price and unemployment levels during the 1960s. Given that correlation does not imply causation (see Part I), we begin...
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