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Adaptive Expectations, Underparameterization and the Lucas Critique

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  • Evans, George W
  • Ramey, Garey

Abstract

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.

Suggested Citation

  • Evans, George W & Ramey, Garey, 2001. "Adaptive Expectations, Underparameterization and the Lucas Critique," University of California at San Diego, Economics Working Paper Series qt41f2h196, Department of Economics, UC San Diego.
    • Handle: RePEc:cdl:ucsdec:qt41f2h196
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    References listed on IDEAS

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    1. 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.
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    4. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 241-254, April.
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    6. Milton Friedman, 1957. "A Theory of the Consumption Function," NBER Books, National Bureau of Economic Research, Inc, number frie57-1.
    7. Cooley, Thomas F & Prescott, Edward C, 1976. "Estimation in the Presence of Stochastic Parameter Variation," Econometrica, Econometric Society, vol. 44(1), pages 167-184, January.
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    More about this item

    Keywords

    Lucas critique; rational expectations;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations

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