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Chapter 25: Q:1 (page 675)

What does the Lucas critique state about the limitations of our current understanding of the way in which the economy works?

Short Answer

Expert verified

The Lucas critique in Economics indicates to us the effect that will be carried upon the policy of price inflation and also that the outputs will be depending on the expectations that will help us make the economic policy more effective.

Step by step solution

01

Step:1 Introduction

In a 1976 article, prominent economist Robert Lucas described how macroeconomic models might be exploited to evaluate changes in economic policy. Lucas' critique is the name given to this piece.

02

Step:2 Explanation

Traditional ways of formulating and evaluating policies, according to Lucas, do not take into account how people would react to politics. This is significant because people's actions have a significant impact on economic policy. People do not always have adaptive expectations, and political creators should not presume that they do. According to Lucas, each policy change enacted by rational workers and businesses will be met with adjustment, depending on the nature of the change and its impact. Economists must evaluate the impact of politics on people's expectations, according to Lucas.

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Most popular questions from this chapter

Suppose an econometric model based on past data predicts a small decrease in domestic investment when the Federal Reserve increases the federal funds rate. Assume the Federal Reserve is considering an increase in the federal funds rate target to fight inflation and promote a low inflation environment that will encourage investment and economic growth.

a. Discuss the implications of the econometric model鈥檚 predictions if individuals interpret the increase in the federal funds rate target as a sign that the Fed will keep inflation at low levels in the long run.

b. What would be Lucas鈥檚 critique of this model?

Suppose the statistical office of a country does a poor job in measuring inflation and reports an annualized inflation rate of 4%for a few months, while the true inflation rate has been 2.5%. What will happen to the central bank's credibility if it is engaged in inflation targeting and its target is around 2%?

Robert Lucas won the Nobel Prize in economics. Go to http:/nobelprize.org/nobel_prizes/economics/ and locate the press release on Robert Lucas. What was his Nobel Prize awarded for? When was it awarded?

Suppose country A has a central bank with full credibility, and country B has a central bank with no credibility. How does the credibility of each country's central bank affect the speed of adjustment of the aggregate supply curve to policy announcements? How does this result affect output stability? Use an aggregate supply and demand diagram to demonstrate.

In what sense can greater central bank independence make the time-inconsistency problem worse?
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