The Empirical Relevance of the Lucas Critique
This paper re-considers the empirical relevance of the Lucas critique using a sticky price model in which a weak central bank response to inflation generates equilibrium indeterminacy. The model is calibrated on the magnitude of the historical shift in the Fed's policy rule and is capable of reproducing the decline in the volatility of postwar U.S. inflation and real activity. Using montecarlo simulations and a backward-looking model of aggregate supply and aggregate demand we find strong and robust evidence of heteroskedasticity, which is shown to introduce a severe downward bias in the statistics of popular parameter stability tests. When the instability of the reduced-form error variances across policy regimes is accounted for the Lucas critique is found to be empirically relevant on artificial data as well as on actual data
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