Policy actions have become increasingly discretionary. Moreover, the financial crisis and associated policy responses have left many central banks operating with their policy rate near the zero lower bound; this means that they are no longer following a systematic rule, if they ever were. Given that central bankers are, in fact, acting in a discretionary manner, whether it is because they are at the zero bound or because they cannot or will not commit, how are we to interpret policy advice coming from models that assume full commitment to a systematic rule? I think this point is driven home by noting that a number of central banks have been openly discussing different regimes, from price-level targeting to nominal GDP targeting. In such an environment where policymakers actively debate alternative regimes, how confident can we be about the policy advice that follows from models in which that is never contemplated?

The Lucas critique, named for Robert Lucas' work on macroeconomic policymaking, argues that it is naïve 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.[1]

The basic idea pre-dates Lucas' contribution (related ideas are expressed as Campbell's Law and Goodhart's Law), but in a 1976 paper Lucas drove home 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."[2]
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 govern individual behavior. 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.[3]

The Lucas critique was influential not only because it cast doubt on many existing models, but also because it encouraged macroeconomists to build microfoundations for their models. Microfoundations had always been thought to be desirable; Lucas convinced many economists they were essential. Real Business Cycle economists, starting with Finn Kydland and Edward Prescott, focused their research on using microfoundations to formulate macroeconomic models. Contemporary macroeconomic models microfounded on the interaction of rational agents are often called dynamic stochastic general equilibrium (DSGE) models.[citation needed]

On this key point, commentators have noticed the contrast between Professor Bernanke and Fed Chairman Bernanke. Advising a depression-struck Japan 10 and more years ago, the professor called for monetary easing by any means necessary. Inflation is too low, he said, so don’t hold back. Actually, make higher inflation rates your goal. Caution and orthodoxy are destroying your economy. Chairman Bernanke, critics say, is failing to follow his own advice.
Vanishing Jobs
This is unfair, but the critics have a point. They are too harsh because the U.S. in 2012 is not Japan in 2001. The economy is growing and prices aren’t falling. The Fed’s decision is a closer call.
Also, don’t entirely dismiss concerns about how soon the economy will run into supply constraints. The main body of research suggests that unemployment can fall a lot further before higher wages start to press on inflation. But reports of skills shortages and a newer strand of academic work raise doubts. A paper by Nir Jaimovich and Henry Siu suggests that the recession may have accelerated “job polarization” -- meaning permanent losses in the middle of the labor force, among workers doing jobs that are skilled yet susceptible to automation. If these positions aren’t coming back, new stimulus might raise the inflation rate sooner than we think.
This gives the Fed’s inflation hawks one more reason to urge caution. And Bernanke has to take their views into account. Monetary policy isn’t his alone to make. He won’t want to find himself in the minority on his own Federal Open Market Committee, the Fed’s policy-making panel. An unintended consequence of FOMC transparency is that it strengthens dissenters. Bernanke won’t argue as strenuously as he might wish for new QE if he thinks he can’t carry a consensus.
A simpler mandate would cut through some of these problems. I’m keen on an old idea that has recently attracted new support. Tell the Fed to target not inflation and full employment but growth in the money value of gross domestic product. A target for growth in nominal GDP is no panacea. It wouldn’t make central banking easy, and you could implement it in different ways -- a further source of contention. But the basic approach has big advantages.
In effect, it merges the two halves of the existing mandate, allowing the Fed to be agnostic, as it should be, about the underlying components. Suppose the target was medium-term growth in nominal GDP of 5 percent a year. That might be inflation of 2 percent and growth in output of 3 percent, or stable prices with 5 percent growth, or zero growth with 5 percent inflation. Obviously those outcomes aren’t equally desirable -- but the point is that the Fed can’t steer the components, only the aggregate.
A Nominal Solution
Monetary stimulus adds to demand. How that demand breaks down between inflation and output is beyond the Fed’s control. The Fed shouldn’t be held accountable for outcomes it cannot direct. And the presentational advantage really matters. At the moment, nominal GDP is less than 4 percent. The Fed would say: According to the mandate, it needs to be increased; in QE, we have the means to increase it. End of discussion.
The argument between inflation hawks and doves isn’t settled, but it’s suspended, which is fine. If the recession has permanently undermined the economy’s capacity to grow, a 5 percent nominal GDP target might yield over time growth of, say, 2 percent a year with inflation of 3 percent, rather than vice versa, as we’d like. Once that becomes clear, we can talk about reducing the nominal GDP target to 4 percent. Meanwhile the 5 percent target keeps inflation within clear bounds without choking off the possibility of faster growth.
With a simpler goal -- one it could actually achieve -- the Fed would have less to argue about and less to explain. It would be more accountable. And transparency would provide clarity, which is stabilizing, rather than the current muddle, which isn’t.

USE of a paper currency is normally taken to be an expression of faith in the government that issues it. Once the solvency of the issuer is in doubt, anyone holding its notes will quickly try to trade them in for dollars, jewellery or, failing that, some commodity with enduring value (when the rouble collapsed in 1998 some factory workers in Russia were paid in pickles). The Somali shilling, now entering its second decade with no real government or monetary authority to speak of, is a splendid exception to this rule.

While insisting he has no wish to return to overpriced homes and lax mortgage standards, he added, “I’m not a believer in the Old Testament theory of business cycles. I think that if we can help people, we need to help people.”

It’s sad that the six studies showing fiscal stimulus works contain 3 that simply assume it works, and 3 that suffer from the fallacy of composition. That’s all they got?

Is there any chance that the dispute between stubborn Keynesians and stubborn monetarists will be settled empirically? I find it difficult to be optimistic on that score. We have accumulated more than six decades of macroeconomic experience since the end of World War II, yet neither stubborn Keynesians nor stubborn monetarists have encountered any data that would make them change their minds. Instead, since 2008, the Keynesians have effectively “taken back” all of the concessions that they made in the 1970s and 1980s.

Jeremy Stein, a professor at Harvard University and a nominee for governor of the Federal Reserve, says excessive private-money creation can leave the financial system too reliant on these forms of short-term debt and vulnerable to a shock. In a paper co-authored with Robin Greenwood and Samuel Hanson, he argues that more government short-term borrowing can reduce harmful private-money creation.