Adaptive Expectations, Underparameterization and the Lucas Critique
A striking implication of the replacement of adaptive expectations by Rational Expectations was the "Lucas Critique," which showed that expectation parameters, and endogenous variable dynamics, depend on policy parameters. We reconsider this issue from the vantage point of bounded rationality. Adaptive expectations, with an optimally tuned parameter, can provide a reasonable, if not fully rational, forecast method when the true process is unknown. We show that for a range of processes, monetary policy remains subject to the Lucas critique. However, there are also regimes in which the expectation parameter is locally invariant and the Lucas critique does not apply.
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- Cooley, Thomas F & Prescott, Edward C, 1973. "Tests of an Adaptive Regression Model," The Review of Economics and Statistics, MIT Press, vol. 55(2), pages 248-56, May.
- Fischer, Stanley, 1977. "Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 85(1), pages 191-205, February.
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- Milton Friedman, 1957. "A Theory of the Consumption Function," NBER Books, National Bureau of Economic Research, Inc, number frie57-1, March.
- Milton Friedman, 1957. "Introduction to "A Theory of the Consumption Function"," NBER Chapters, in: A Theory of the Consumption Function, pages 1-6 National Bureau of Economic Research, Inc.
- Cooley, Thomas F & Prescott, Edward C, 1973. "An Adaptive Regression Model," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 14(2), pages 364-71, June.
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