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The Lucas critique and the stability of empirical models

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  • Thomas A. Lubik

    (Research Department, Federal Reserve Bank of Richmond, VA, USA)

  • Paolo Surico

    (London Business School, London, UK, and CEPR)

Abstract

This paper reconsiders the empirical relevance of the Lucas critique using a DSGE sticky price model in which a weak central bank response to inflation generates equilibrium indeterminacy. The model is calibrated to capture the magnitude of the historical shift in the Federal Reserve's policy rule. Using Monte Carlo simulations and a backward-looking model of aggregate supply and demand, we find that shifts in the policy rule induce breaks in both the reduced-form coefficients and the reduced-form error variances. When the instability of the reduced-form error variances is accounted for, the Lucas critique is found to be empirically relevant. Copyright © 2009 John Wiley & Sons, Ltd.

Suggested Citation

  • Thomas A. Lubik & Paolo Surico, 2010. "The Lucas critique and the stability of empirical models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 25(1), pages 177-194.
  • Handle: RePEc:jae:japmet:v:25:y:2010:i:1:p:177-194 DOI: 10.1002/jae.1129
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    2. Lombardi, Marco J. & Sgherri, Silvia, 2007. "(Un)naturally low? Sequential Monte Carlo tracking of the US natural interest rate," Working Paper Series 794, European Central Bank.
    3. Jan Čapek, 2016. "Structural Changes in the Czech Economy: A DSGE Model Approach," Prague Economic Papers, University of Economics, Prague, pages 37-52.
    4. Da Silva, Sergio, 2009. "Does Macroeconomics Need Microeconomic Foundations?," Economics Discussion Papers 2009-3, Kiel Institute for the World Economy (IfW).
    5. Doiron, Denise & Fiebig, Denzil G. & Suziedelyte, Agne, 2014. "Hips and hearts: The variation in incentive effects of insurance across hospital procedures," Journal of Health Economics, Elsevier, vol. 37(C), pages 81-97.
    6. Florian Heider & Roman Inderst, 2012. "Loan Prospecting," Review of Financial Studies, Society for Financial Studies, pages 2381-2415.
    7. Michiel van Leuvensteijn & Jacob Bikker & Adrian van Rixtel & Christoffer Kok Sørensen, 2011. "A new approach to measuring competition in the loan markets of the euro area," Applied Economics, Taylor & Francis Journals, vol. 43(23), pages 3155-3167.
    8. Marvin Goodfriend & Robert G. King, 2001. "The Case for Price Stability," NBER Working Papers 8423, National Bureau of Economic Research, Inc.
    9. Lubik, Thomas A. & Matthes, Christian, 2016. "Indeterminacy and learning: An analysis of monetary policy in the Great Inflation," Journal of Monetary Economics, Elsevier, pages 85-106.
    10. Thomas A. Lubik & Paolo Surico, 2010. "The Lucas critique and the stability of empirical models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., pages 177-194.
    11. Otilia Boldea & Alastair R. Hall, 2013. "Testing structural stability in macroeconometric models," Chapters,in: Handbook of Research Methods and Applications in Empirical Macroeconomics, chapter 9, pages 206-228 Edward Elgar Publishing.
    12. Luca Fanelli & Marco M. Sorge, 2015. "Indeterminacy, Misspecification and Forecastability: Good Luck in Bad Policy?," CSEF Working Papers 402, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
    13. Liu, Yuelin & Morley, James, 2014. "Structural evolution of the postwar U.S. economy," Journal of Economic Dynamics and Control, Elsevier, vol. 42(C), pages 50-68.
    14. Castelnuovo, Efrem & Greco, Luciano & Raggi, Davide, 2008. "Estimating regime-switching Taylor rules with trend inflation," Research Discussion Papers 20/2008, Bank of Finland.
    15. Florin O. Bilbiie & Roland Straub, 2013. "Asset Market Participation, Monetary Policy Rules, and the Great Inflation," The Review of Economics and Statistics, MIT Press, pages 377-392.
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    17. Marco Cozzi, 2012. "Risk Aversion Heterogeneity, Risky Jobs and Wealth Inequality," Working Papers 1286, Queen's University, Department of Economics.
    18. Yuriy Gorodnichenko & Marianna Kudlyak & John Mondragon & Olivier Coibion, 2014. "Does Greater Inequality Lead to More Household Borrowing? New Evidence from Household Data," 2014 Meeting Papers 402, Society for Economic Dynamics.
    19. Canova, Fabio & Lopez-Salido, Jose David & Michelacci, Claudio, 2007. "The Labour Market Effects of Technology Shocks," CEPR Discussion Papers 6365, C.E.P.R. Discussion Papers.
    20. Milani, Fabio, 2014. "Learning and time-varying macroeconomic volatility," Journal of Economic Dynamics and Control, Elsevier, vol. 47(C), pages 94-114.
    21. Lubik, Thomas A. & Matthes, Christian, 2016. "Indeterminacy and learning: An analysis of monetary policy in the Great Inflation," Journal of Monetary Economics, Elsevier, pages 85-106.
    22. Yash P. Mehra & Devin Reilly, 2009. "Short-term headline-core inflation dynamics," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 289-313.

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