The Lucas Critique

According to the Phillips curve equation, unemployment rate and inflation rate are negatively related. Therefore, there exists a tradeoff between rate of inflation and unemployment in any economy. For a social decision maker, this decision involves sacrifice in either in terms of inflation or in terms of unemployment. But there is another way which may reduce the tradeoff and help in reducing inflation without affecting the unemployment much – The Lucas critique. Robert Lucas is the winner of Nobel memorial prize in economic sciences for his contribution in the fields of rational expectations.

Robert Lucas, an American economist claimed in his thesis that when trying to predict the effects of major policy change, using just the past data can be misleading. In the case of Phillips curve relation, he stated that if the monetary authorities made necessary policy changes then the Phillips curve relation will break.

To make it clear let’s first understand the Phillips curve relation. The Philips curve equation is π_t – π^e = – α (u_t – u_n) where π^e is the expected rate of inflation. Expectation of the inflation rate is an important determinant of the actual inflation rate. The economic agents form the expectations on the basis of past trend of the inflation rate. It implies that if inflation in year 1 is rising then in year 2 the agents will change their expectation of inflation upwards. According to Lucas Critique, economic agents must take into account the policy changes while forming the expectations. If the central bank introduces policies targeting lower inflation and the wage setters or other economic agents are well convinced with the central bank’s attempt, then the actual inflation would fall without the need for a higher unemployment and recession.

The most significant assumption behind this process is the credibility of the central bank. The economic agents will reform their expectations only when they believe the policies of central bank will lower the inflation. If the credibility of central bank is faded away then again the agents may revise their expectations of the inflation rate upwards. Therefore, economists believe that the central bank should prove their commitment towards lowering the inflation rate in order to achieve a positive result. Also once the credibility is established the central bank must go for fast disinflation as slow disinflation may reduce the credibility. Credibility decreases the unemployment cost of disinflation.

Robert lucas’ contribution in the fields of rational expectations is very significant. His theories changed the old Keynesian way of economics. Lucas critique is one of them..!!

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