Question

a. What is the Lucas critique? Why does it matter? Illustrate your answer with references to a famous episode in U.S. monetary history.

b. Using your knowledge from this course, assess the extent to which the European Monetary Union is a successful system of fixed exchange rates in comparison with the United States of America.

Answer 1

a. In a 1976 article he introduced what is now known as the “Lucas critique” of macroeconometric models, showing that the various empirical equations estimated in such models were from periods where people had particular expectations about government policy. Once those expectations changed, as his theory of rational expectations said they would, then the empirical equations would change, making the models useless for predicting the results of different fiscal and monetary policies. So, for example, if an econometric model showed that for some time period a three-percentage-point drop in inflation was accompanied by a two-percentage-point increase in unemployment, one could not use this correlation to predict the effect of a future three-percentage-point drop in inflation, because people’s expectations would not be the same as they were in the time period for which this relation was estimated. One important implication of Lucas’s work, which was confirmed by Thomas Sargent, is that a government that is credible—that is, a government that makes itself understood and believed—can quickly end a major inflation without a big increase in unemployment. The reason: government credibility will cause people to quickly adjust their expectations. The key to that credibility, wrote Sargent, is fiscal policy. If governments commit to balanced budgets, then one of their main motives for inflation is gone

The Lucas critique, named for Robert Lucas's work on macroeconomic policymaking, argues that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. More formally, it states that the decision rules of Keynesian models—such as the consumption function—cannot be considered as structural in the sense of being invariant with respect to changes in government policy variables. The Lucas critique is significant in the history of economic thought as a representative of the paradigm shift that occurred in macroeconomic theory in the 1970s towards attempts at establishing micro-foundations. The basic idea pre-dates Lucas's contribution—related ideas are expressed as Campbell's law and Goodhart's law—but in a 1976 paper, Lucas drove to the point that this simple notion invalidated policy advice based on conclusions drawn from large-scale macroeconometric models. Because the parameters of those models were not structural, i.e. not policy-invariant, they would necessarily change whenever policy (the rules of the game) was changed. Policy conclusions based on those models would therefore potentially be misleading. This argument called into question the prevailing large-scale econometric models that lacked foundations in dynamic economic theory. Lucas summarized his critique: "Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models." The Lucas critique is, in essence, a negative result. It tells economists, primarily, how not to do economic analysis. The Lucas critique suggests that if we want to predict the effect of a policy experiment, we should model the "deep parameters" (relating to preferences, technology, and resource constraints) that are assumed to govern individual behavior: so-called "microfoundations." If these models can account for observed empirical regularities, we can then predict what individuals will do, taking into account the change in policy, and then aggregate the individual decisions to calculate the macroeconomic effects of the policy change. Thanks to the Lucas critique, the old-style Keynesian macroeconomics is now regarded as having a limited scope. Today societies and politicians hardly accept the direct and unlimited success of countercyclical economic policy highlighted by John Maynard Keynes. For Keynes, fiscal policy has the hope of countercyclical success, though he himself also referred to some limits in the form of expectations. This was the problem that was examined by both Milton Friedman and Robert Lucas. However, deeply, the core idea of Keynesian countercyclical economic policy remained intact all along: there are situations in which government intervention may be successful in real terms. This is the consequence of the conditional character of the theory of new classical macroeconomics. However, the exact circumstances under which this countercyclical potential is available underwent serious modifications. Today, thanks to the new classicals, we have a deeper understanding of these limiting factors. Shortly after the publication of Lucas's article, Kydland and Prescott published the article "Rules rather than Discretion: The Inconsistency of Optimal Plans", where they not only described general structures where short-term benefits are negated in the future through changes in expectations, but also how time consistency might overcome such instances.

b. The idea of a monetary union in Europe arose already in the late 1960ies. After ten years of experience with the European Monetary System, the European Council finally decided in 1989 to plan and implement a monetary union. The European Monetary System was a fixed exchange rate system with adjustable parities and can be seen as a predecessor of the monetary union. In 1992 the Treaty on the European Union was signed. It included among several other topics a three-step plan for the realization of the EMU which should start by the end of the century. A monetary union is defined by the irrevocable fixing of the exchange rates of participating currencies and the centralization of monetary policy, here assigned to the European Central Bank in Frankfurt that is located in Germany. Replacement of the national currencies by one single currency, like the Euro in EMU, is not absolutely necessary but is making sense to reduce transaction costs . The European Monetary Union started on 1 January 1999 with 11 countries, with Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland. It was clear from the beginning that economic convergence is necessary for membership in the EMU. With the loss of exchange rate adjustments in a monetary union it is crucial to have participating economies that do not differ very much regarding structure, productivity, productivity growth rates and GDP growth rates. Therefore convergence criteria were listed that had to be fulfilled by the countries before joining the EMU.

Price stability is the explicit superior goal of the ECB and therefore should be evaluated when discussing the success of the monetary union. The ECB stands in the tradition of monetaristic central bank policy – like many other central banks. With the fixing of the exchange rate and the introduction of the Euro market participants no longer face exchange rate risks within the EMU. This is the main advantage that should foster growth of the countries’ GDPs with higher trade volumes. Some other advantages are connected to this first one. Prices can be compared more easily, information costs are reduced, competition is increased. With only one currency transaction costs are minimized. Finally, the single currency for such a large currency area works as an international reserve currency, in addition to US-Dollar and Yen. Of course, it takes some time to have all these advantages fully unfold. From the advantages above we can expect GDP growth as one indicator of a successful monetary union. One other set of advantages of a monetary union is described for example in Mongelli and Vega . Normally and very importantantly, it is stressed that we need convergence for having an optimum currency area (OCA).An optimum currency area only includes countries with higher gains than losses from participating in the monetary union. Gains are described above. Losses are attributed to the fact that the country cannot conduct independent monetary policy for national economic stability. Monetary policy is centralized and conducted by one joint central bank. Briefly summarized, gains and losses depend on the level of economic integration between the participating countries. Integration generally is defined as a high level of factor mobility between the countries. Gains increase with increasing integration as the main advantage, lack of exchange rate risk with a predictable basis for decisions, is more important if we have a high trade volume, for example. Losses will be reduced with increasing integration. With high factor mobility in a currency area internal and external shocks will have a lo