Worth: Mankiw Economics 5e 386 PART V Macroeconomic Policy Debates of future income, and firms decide how much to invest based on expectations of future profitability. These expectations depend on many things, including the eco- nomic policies being pursued by the government. Thus, when policymakers esti- mate the effect of any policy change, they need to know how people's expectations will respond to the policy change. Lucas has argued that traditional methods of policy evaluation- such as those that rely on standard macroeconometric mod- els--do not adequately take into account this impact of policy on expectations This criticism of traditional policy evaluation is known as the Lucas critique o: An important example of the Lucas critique arises in the analysis of disinfla- nAs you may recall from Chapter 13, the cost of reducing inflation is often measured by the sacrifice ratio, which is the number of percentage points of GDP that must be forgone to reduce inflation by 1 percentage point. Because hese estimates of the sacrifice ratio are often large, they have led some econo- mists to argue that policymakers should learn to live with inflation, rather than Incur the large cost of reducing it. According to advocates of the rational-expectations approach, however, these es- timates of the sacrifice ratio are unreliable because they are subject to the Lucas cri- tique. Traditional estimates of the sacrifice ratio are based on adaptive expectations, that is, on the assumption that expected inflation depends on past inflation. Adaptive expectations may be a reasonable premise in some circumstances, but if the policy makers make a credible change in policy, workers and firms setting wages and prices will rationally respond by adjusting their expectations of inflation appropriately. This change in inflation expectations will quickly alter the short-run tradeoff between fation and unemployment. As a result, reducing inflation can potentially be much less costly than is suggested by traditional estimates of the sacrifice ratio The Lucas critique leaves us with two lessons. The narrow lesson is that econo- mists evaluating alternative policies need to consider how policy affects expecta- nd, thereby, behavior. The broad lesson is that policy evaluation is hard,so economists engaged in this task should be sure to show the requisite humility. The historical record In judging whethe er government po olicy should play an active or passive role in the economy, we must give some weight to the historical record. If the economy has experienced many large shocks to aggregate supply and aggregate demand, and if policy has successfully insulated the economy from these shocks, then the case for active policy should be clear. Conversely, if the economy has experienced few rge shocks, and if the fuctuations we have observed can be traced to inept eco- omic policy, then the case for passive policy should be clear. In other words,our view of stabilization policy should be influenced by whether policy has histori- cally been stabilizing or destabilizing. For this reason, the debate over macroeco- nomic policy frequently turns into a debate over macroeconomic history. Yet history does not settle the debate over stabilization policy. Disagree ments over history arise because it is not easy to identify the sources of Robert E. Lucas, Jr, "Econometric Policy Evaluation: A Critique, " Carnegie Rochester Conference on Public Policy 1(Amsterdam: North-Holland, 1976), 19-46. User JoENA: Job EFFo1430: 6264_ch14: Pg 386: 27872#/eps at 100s Mon,Feb18,20021:024MUser JOEWA:Job EFF01430:6264_ch14:Pg 386:27872#/eps at 100% *27872* Mon, Feb 18, 2002 1:02 AM of future income, and firms decide how much to invest based on expectations of future profitability.These expectations depend on many things, including the eco￾nomic policies being pursued by the government.Thus, when policymakers esti￾mate the effect of any policy change,they need to know how people’s expectations will respond to the policy change. Lucas has argued that traditional methods of policy evaluation—such as those that rely on standard macroeconometric mod￾els—do not adequately take into account this impact of policy on expectations. This criticism of traditional policy evaluation is known as the Lucas critique. 2 An important example of the Lucas critique arises in the analysis of disinfla￾tion. As you may recall from Chapter 13, the cost of reducing inflation is often measured by the sacrifice ratio, which is the number of percentage points of GDP that must be forgone to reduce inflation by 1 percentage point. Because these estimates of the sacrifice ratio are often large, they have led some econo￾mists to argue that policymakers should learn to live with inflation, rather than incur the large cost of reducing it. According to advocates of the rational-expectations approach, however, these es￾timates of the sacrifice ratio are unreliable because they are subject to the Lucas cri￾tique.Traditional estimates of the sacrifice ratio are based on adaptive expectations, that is,on the assumption that expected inflation depends on past inflation.Adaptive expectations may be a reasonable premise in some circumstances, but if the policy￾makers make a credible change in policy,workers and firms setting wages and prices will rationally respond by adjusting their expectations of inflation appropriately.This change in inflation expectations will quickly alter the short-run tradeoff between inflation and unemployment.As a result, reducing inflation can potentially be much less costly than is suggested by traditional estimates of the sacrifice ratio. The Lucas critique leaves us with two lessons.The narrow lesson is that econo￾mists evaluating alternative policies need to consider how policy affects expecta￾tions and, thereby, behavior.The broad lesson is that policy evaluation is hard, so economists engaged in this task should be sure to show the requisite humility. The Historical Record In judging whether government policy should play an active or passive role in the economy, we must give some weight to the historical record. If the economy has experienced many large shocks to aggregate supply and aggregate demand, and if policy has successfully insulated the economy from these shocks, then the case for active policy should be clear. Conversely, if the economy has experienced few large shocks, and if the fluctuations we have observed can be traced to inept eco￾nomic policy, then the case for passive policy should be clear. In other words, our view of stabilization policy should be influenced by whether policy has histori￾cally been stabilizing or destabilizing. For this reason, the debate over macroeco￾nomic policy frequently turns into a debate over macroeconomic history. Yet history does not settle the debate over stabilization policy. Disagree￾ments over history arise because it is not easy to identify the sources of 386 | PART V Macroeconomic Policy Debates 2 Robert E. Lucas, Jr., “Econometric Policy Evaluation: A Critique,’’ Carnegie Rochester Conference on Public Policy 1 (Amsterdam: North-Holland, 1976), 19–46