Modern Macroeconomics.pdf

The new classical school 265relationship. Obviously the behaviour of this type of model will, among otherthings, depend on the estimated value of the coefficients of the variables inthe model. For example, such models typically include a consumption functionas one of the key relationships. Suppose the consumption function takesthe following simple form: C = α + β(Y – T). That is, consumption isproportional to disposable (after tax) income (Y – T). However, in this simpleKeynesian consumption function the parameters (α, β) will depend on theoptimal decisions that economic agents made in the past relating to howmuch to consume and save given their utility function; that is, these parameterswere formed during an earlier optimization process directly influencedby the particular policy regime prevailing at the time. Lucas argues that wecannot use equations such as this to construct models for predictive purposesbecause their parameters will typically alter as the optimal (consumption)responses of rational utility-maximizing economic agents to the policy changeswork their way through the model. The parameters of large-scale macroeconometricmodels may not remain constant (invariant) in the face of policychanges, since economic agents may adjust their expectations and behaviourto the new environment (Sargent, 1999, refers to this as the problem of‘drifting coefficients’). Expectations play a crucial role in the economy becauseof the way in which they influence the behaviour of consumers, firms,investors, workers and all other economic agents. Moreover, the expectationsof economic agents depend on many things, including the economic policiesbeing pursued by the government. If expectations are assumed to be rational,economic agents adjust their expectations when governments change theireconomic policies. Macroeconometric models should thus take into accountthe fact that any change in policy will systematically alter the structure of themacroeconometric model. Private sector structural behavioural relationshipsare non-invariant when the government policy changes. Thus, estimating theeffect of a policy change requires knowing how economic agents’ expectationswill change in response to the policy change. Lucas (1976) argued thatthe traditional (Keynesian-dominated) methods of policy evaluation do notadequately take into account the impact of policy on expectations. Therefore,Lucas questioned the use of such models, arguing that:given that the structure of an econometric model consists of optimal decision rulesof economic agents, and that optimal decision rules vary systematically withchanges in the structure of series relevant to the decision maker, it follows that anychange in policy will systematically alter the structure of econometric models.In other words, the parameters of large-scale macroeconometric models areunlikely to remain constant in the face of policy changes, since rational economicagents may adjust their behaviour to the new environment. Becausethe estimated equations in most existing Keynesian-style macroeconometric