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IAI Actuarial Core Principles · Business Economics · Main economic schools and their key features

The Lucas critique is best described as which of the following arguments?

The Lucas critique says empirical relationships estimated under one policy regime are unreliable for judging a new policy, because rational agents change their behaviour when they expect the policy to differ. Such relationships are therefore not stable structural guides for policymakers.

  1. ARelationships estimated from past data may break down when policy changes, because agents alter behaviour as their expectations of policy changeCorrect
  2. BAggregate supply is vertical only in the long run, so demand policy is always effective
  3. CMenu costs are too small to explain price stickiness
  4. DInterest rates cannot be set by central banks
  5. Entrepreneurial knowledge is dispersed, so planning cannot work

Explanation

Lucas argued that macroeconometric relationships such as the Phillips curve are not structural; they depend on expectations formed under the old policy regime. A policy shift changes expectations and so changes the relationship, making simulations based on old data unreliable. The last option is Hayek's knowledge problem and is distinct.

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