Beyond the Lucas Critique

This chapter discusses the author’s early attempts to address the Lucas Critique. It argues that the effectiveness of a policy regime depends on the reference model that people believe accurately reflects the economy. If the reference model changes, people’s expectations and behaviors will also change. This, in turn, alters the impact of new policy rules compared to those based on the old model. The chapter shows that in an economy agents do not only adjust their behavior in response to policy changes, thereby altering historical responses; they also modify their response to policy changes based on the model of the economy they believe correctly represents the economy. Consequently, monetary policy may or may not be effective depending on: (i) the economic model adopted (albeit conventionally) by the agents and (ii) the behaviors that agents consider rational (in accordance with the accepted convention) and consequently adopt. Importantly, in evaluating the effectiveness of monetary policy, understanding the prevailing conventions that lead agents to accept a model as “true” is more rimportant than pinpointing the ontologically “true” model of the economy.