Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Taking aim with the Lucas critique

The 1970s were a time of great tumult in macroeconomics, not only because of the breakdown of the Phillips curve (which at the time economists struggled to explain), but also resulting from a devastating critique of macroeconomics due to Robert E. Lucas, Jr (what a cool name).

In 1976, Lucas wrote a paper arguing that trying to predict the effects of a change in economic policy based on past historical data is a serious mistake because past historical data reflected the economic policy of those times. If a government changes economic policy today, it has no guarantee that those relationships between variables will continue to hold.

Lucas argued that the key to understanding the impact of policy changes was explicitly to take into account how people’s expectations

would change when a new policy was announced.

The Phillips curve is an excellent example of the Lucas critique in action. Before policy makers understood the relationship between unemployment and inflation and were therefore unable to exploit this relationship, rational individuals expected inflation to be zero (see the preceding section). This situation meant that, when inflation was unusually high (that is, positive), the economy experienced a boost that reduced unemployment; when it was unusually low (negative), the economy experienced a knock that increased unemployment.

But when policy makers understood the relationship and tried to exploit it by creating persistently positive inflation, rational individuals started to expect positive inflation (that is, their expectations changed). Thus they were no longer ‘surprised’ when inflation was high and so no reason existed for unemployment to fall.

As in the crying baby analogy with which we begin this chapter, if the baby doesn’t expect his parents to arrive when he cries and someone does, he stops crying. But when he learns that someone comes when he cries, his expectations change, which causes his behaviour to change: he now cries more regularly even though he’s being comforted more regularly!

The lesson of this story isn’t that you shouldn’t comfort babies when they cry (economists aren’t that mean!), but that when considering a change of tack – in any walk of life – you need to consider how other people’s expectations are likely to change. You can’t just trust a statistical relationship that held in the past under some other policy.

The Lucas critique was so devastating because it meant that much of macroeconomics had to be rethought because it didn’t explicitly take into account expectations. A lot of the collective wisdom of macroeconomics was, at best, potentially misleading, and at worst just plain wrong. Macroeconomists spent much of the next few decades taking expectations into account explicitly.

Zeroing in on the Short-and Long-Run