Sunday, July 22, 2012

The Lucas Critique and the hard-money consensus

The Lucas Critique is simple, and it is correct. If you have a model of the economy that works pretty well, and you try to use that model to predict the effects of a new policy, the policy may change people's behavior so that your model no longer works pretty well, thus leading (among other things) to the policy failing to have its intended effect.

The Lucas Critique was applied by Lucas to invalidate many of the "Phillips Curve" models of the 1970s. The idea was that if central banks cause inflation in an attempt to pump up growth, people will start expecting higher inflation in general, and the inflation-growth relationship that held in the past would change. That seems to have been borne out by the events of the 70s. And so people started to think that the Lucas Critique was of great practical importance.

The Lucas Critique still figures prominently in debates between macroeconomists today. Here is Charles Plosser, one of the founders of "Real Business Cycle" theory, criticizing the New Keynesian DSGE models that are popular nowadays:

In my view, the current rules of the game of New Keynesian DSGE models run afoul of the Lucas critique... 
I have always been uncomfortable with the New Keynesian model’s assumption that wage and price setters have market power but, at the same time, are unable or unwilling to change prices in response to anticipated and systematic shifts in monetary policy. This suggests that the deep structure of nominal frictions in New Keynesian DSGE models should do more than measure the length of time that firms and households wait for a chance to reset their prices and wages... 
When the real and nominal frictions of New Keynesian models do not reflect the incentives faced by economic actors in actual economies, these models violate the Lucas critique’s policy invariance dictum, and thus, the policy advice these models offer must be interpreted with caution... 
During the 1980s and 1990s, it was quite common to hear in workshops and seminars the criticism that a model didn’t satisfy the Lucas critique. I thought this was often a cheap shot because almost no model satisfactorily dealt with the issue. And during a period when the policy regime was apparently fairly stable — which many argued it mostly was during those years — the failure to satisfy the Lucas critique seemed somewhat less troublesome. However, in my view, throughout the crisis of the last few years and its aftermath, the Lucas critique has become decidedly more relevant.
First, let me say that I agree with Plosser: Calvo pricing, which is one feature of New Keynesian models about which Plosser is complaining, seems to me not to satisfy the Lucas Critique. (As Plosser points out elsewhere, it also looks to be simply false.) Models in which firms choose when to change their prices are much more desirable. Of course, people are working on these. They are really hard to do, since the decision to change prices can depend on all sorts of weird, hard-to-aggregate stuff, like coordination with other price-setters. This kind of realistic behavior is very hard to shoehorn into the kludgey modeling framework of DSGE, which is why the New Keynesians have been forced to adopt Calvo Pricing as a modeling convenience.

But I digress. What I really want to talk about is the question of how a model satisfies the Lucas Critique.

Plosser says that "almost no model [has] satisfactorily dealt with the [Lucas Critique]." This implies that some of them do. How do we identify the few that do?

In a science, the way you establish the correctness or incorrectness of a proposition is by looking at some sort of real-world evidence. What kind of real-world evidence would allow macroeconomists to know that one of their models is policy-invariant? Well, you could have a central bank try out some policies as an experiment, and see if the model's predictions held up. Or you could call up Blizzard Entertainment and get them to flood Diablo III with virtual gold, or something like that.

Alternatively, you could understand the behavior of individual consumers and firms really, really well, and then find some way to aggregate them that is robust in agent-based simulations. In other words, we could get real microfoundations. This is extremely hard to do, of course.

But this is not actually what macroeconomists do when the subject of the Lucas Critique is brought up. Instead of looking at evidence, what they do is make a judgment call. If all the pieces of a model sort of intuitively seem like things that wouldn't change under different policy regimes, then people nod their heads and say "OK, that seems like it satisfies the Lucas Critique", and they think no more of it. This basically happened with RBC models. "Technology shocks" sound like something that people don't control, and that therefore couldn't change if policy changed. And people assumed that the other features of the model (costless price changes, for example) would hold up under different policy regimes as well. So RBC was thought to have satisfied the Lucas Critique.

But if someone says "Hey, these shocks don't seem structural," or "Hey, I think agents in this model would change their actions in response to policy, don't you?", then there is no consensus, and a vocal group of dissenters continues to say that a model "fails the Lucas Critique". This is what has happened with New Keynesian models. To see how this works, check out this 2008 paper by Chari, Kehoe, and McGrattan of the Minneapolis Fed. They discuss the Smets-Wouters model, widely considered to be the "best" of the New Keynesian models:
The Smets-Wouters model has seven exogenous random variables. We divide these into two groups. The potentially structural shocks group includes shocks to total factor productivity, investment-specific technology, and monetary policy. The dubiously structural shocks group includes shocks to wage markups, price markups, exogenous spending, and risk premia.
How do the authors decide which shocks are "potentially structural"? They don't say. The "dubiously structural shocks" are labeled "dubious" because of a mix of evidence and reasonable-sounding thought experiments that show how these shocks change, or might change, in response to changing economic conditions.

But of the "potentially structural" shocks they say nothing. They simply give technology and policy shocks a free pass. These parts of the model are thus judged to "satisfy" the Lucas Critique because no macroeconomists - or, at least, none who matter! - happen to be concerned about whether they satisfy the Lucas Critique.

In other words, the decision of whether a model satisfies the Lucas Critique is made not by evidence, but by the consensus judgment of macroeconomists.

This is just one more judgment call in macro. Which means one more place where personal and political bias can creep in. In the comments on my earlier post, someone wrote: "I think of the Lucas Critique as a gun that only fires left." What that means is that in practice, the Lucas Critique is generally brought up as an objection to models in which the central bank can stabilize output. Or in other words, consensus has a well-known hard-money bias.

Update: Steve Williamson offers some thoughts, especially this:
[W]hat's the big deal? Noah seems endlessly perturbed that economics is not like the natural sciences. There are no litmus tests that allow us to throw out bad theories so we can be done with them. But that makes economics fun. We have to be creative about using the available empirical evidence to reinforce our arguments. We have to be much more creative on the theoretical side than is the case in the natural sciences. We get to have interesting fights in public. Who could ask for more?
File this under "things I cannot possibly argue with"...


  1. Out of curiosity Noah Smith, have you read Keynes's criticisms of Tinbergen, Koopmans, and the rest of the econometricians? Keynes's correspondence with them reveals that the Lucas Critique is really a footnote to Keynes's criticisms of the mathematical tools the econometricians were using at the time. I think this is alluded to in Hugo A. Keuzenkampf's Probability, Econometrics, and Truth, a book which is highly recommended by Dr. Michael Emmett Brady. See the links below.

  2. Odd that you didn't link Lucas's prognostications to your previous post regarding the big change in the early 70's.

    The Phillips curve works perfectly well if you are talking about real wages, see an excellent discussion here:

    And that was fine prior to the breakdown of Bretton Woods where nominal wages were pinned to real wages via the gold standard.

    People didn't suddenly get wise to economics a la Lucas in the 70's, the economic system changed fundamentally - as you yourself noted.

    Even the most casual of observers will note the extraordinary inability of economic actor to learn from history. Thats why we keep having housing bubbles, stock bubbles, crashes and extraordinary write downs on investment.

    The Lucas critique has become a useful counsel of despair for the right wing to prevent any actions to control the excesses of capital, and a sad preventer of effective new research in economics.

  3. Anonymous3:02 PM

    Interesting, the Lucas critique is an other example of recursion, or "feedback loop" as the chaos guys called it.
    I discovered there are some youtube videos on recursion.
    My preferred presentation of recursion is that for programmers, more then that for mathematicians, the following can be understood even by non programmers, given that python language is quite similar to pseudo-code:
    here a nice video about recursion and the tower of Hanoi puzzle (unfortunately no sound!)
    more complicated example on youtube...

    anyway going back to Lucas, it remembered me of a reasoning by Popper on a similar problem about laws of nature, something like "are there regularities in nature?" K.Popper, Postscript to the logic of scientific discovery, Book 1, Realism and the aim of science, Chapter 1, Section 5.

    I guess we can reformulate the whole thing in this way: when our theory fails is because the theory is wrong or because the universe started behaving differently?
    One simple reply (I don't remember if Popper used it) could be: even if the universe started to behave differently your theory failed to foretell it.
    More explicitly: the universe is always changing, what we're looking for are regularities in that changing, if we thought to have find one and at a certain point a new event break our expectation, that means it wasn't a regularity, or better, that regularity was limited to some subset of events.

    This is very much what happened with Newton theory of gravity, it works well in tracing the regularities on a special subset of events happening in the universe, those not near to the speed of light.

    So an argument like "if central banks cause inflation in an attempt to pump up growth, people will start expecting higher inflation in general, and the inflation-growth relationship that held in the past would change" used in order to show that a theory/model is wrong seems to me quite messy. I guess it feels intellectually wit because it uses recursion, but if it is true that central bank behavior can change the functional relationship between inflation and growth this means that this relationship is not a "natural law", or better it's not a regularity, in fact it changes! So perhaps it's just that the regularity, described by the model, is not just between the two variables of inflation and growth but among three: inflation, growth and "central bank behavior", but then we need a way to measure the last one in a consistent way.

    I am not sure if I am able to explain what I mean... but it's quite related to what I can't understand about macro-economics: why there's not just a set of consistently measurable variables and a theory (set of equations) about how a change in one variable affect the others?
    This is also related to the issue of micro-foundations: in physics "macro" thermodynamic worked well without any need of micro-foundations, it was and it is testable at its own "macro" level, period.
    So why this didn't happen in economics? this question of course arises because I had an expectation: that economic science would proceed as physics did, so that there is an isomorphism between the two... this perhaps is a naive expectation given the fact that a thermodynamic system and an economy are two different things (maybe) and so why postulating to be an isomorphism between the two? But it's not so naive either, I mean we all think that even if the system studied manifest different regularities, scientists of any field of study should pursue the same goal: finding those regularities, if present.
    But it becomes a sociological question when formulated as: why economists and physicists manifest different regularities in their way of theorizing and checking their theories?

    OK, sorry, I went too long...

  4. Anonymous4:11 PM

    OK, can we at least all agree that the Lucas Critique should really be called the Hari Seldon Critique? It would make these discussions much more enjoyable.

  5. That is, if you identify the left with easy money. But why should you?

    In any case, I think people accept the Lucas critique easier when it comes to money because we do in fact have several natural experiments, countries that pursued high inflation or hyperinflation. He used this data in his 1978 paper (if I remember correctly) to test his theory, and found that monetary shocks do indeed have a bigger real effect in places where inflation has a smaller variance (hence people are caught by surprise). On other issues the evidence is more scarce. But even so, there are ways to introduce some price stickiness in ways that are consistent with the Lucas critique. See for example this paper by Liu and Huang (2004) published in the AER.

    1. That is, if you identify the left with easy money. But why should you?

      Now you trollin', California.

  6. To an outsider used to dealing with actual scientific theories, the speculations of you economists seem to be fatally underdetermined by the evidence. Your model building features more epicycles than Ptolemy's cosmology, though that analogy is rather unfair to Ptolemy since geocentrism, after all, could at least predict eclipses whereas your theories apparently can't predict anything or, more accurately, can be used to predict anything you want them to. What we have here is something like a cross between astrology and late Scholasticism. When Todo pulled the curtain away from the Wizard of Oz, he at least admitted he was, after all, a humbug. You folks, on the other hand, will go on publishing papers on Whether the Chimera, Bombinasting in the Void, Can be Nourished on Second Intentions. Well, I guess there is a microeconomic foundation for that approach: whatever the market will bear. As long as people go on buying this stuff...

  7. the policy may change people's behavior so that your model no longer works pretty well

    First, this was the insight of Soros, stolen by Lucas.

    Second, Lucas is wrong for an entirely different reason. Economic policy is also foreign policy.

    If, for example, we announce a firm price target, given the role of foreign priced oil in our economy, we change the behavior of S.A. and Iran, who will extort by threatening to raise the price of oil. In fact, every time we control prices we play into their hands.

    You asked a couple of days ago, about the economy appearing to be broken. I would argue that it is substantially likely to be the result of our trying to control prices when we cannot do such because we cannot control the price of oil. When we control prices, other than oil prices, we invite oil price shocks from out enemies, for by controlling other prices we make ourselves weaker and weaker, arriving at where we are, today.

    In sum, economists like Lucas are, in Munger's words in the Psychology of Human Misjudgment, men with a hammer. In the real, irrational world, there are no "rules" or policies, only moves on the never ending chess board of life. IOW Noah, you need to go read Col. John Boyd fast.

    1. Anonymous7:19 AM

      Really? The Lucas critique paper was published 1976. It's more plausible that the influence went the other way, though I'm sure that in reality the two ideas developed completely independently.

    2. Soros did and completed his thinking on Reflexivity between 1959 and 1963 and then started using such to guide his investing, so he was 15 year ahead of Lucas.

      I believe it very important to show that "lay thinking," is substantially ahead of economists.

      We wouldn't be here, today, if the academy and the country had paid attention to Soros, Buffett, and Munger.

    3. Anonymous5:22 AM

      But nobody had heard of Soros by then. Even if he had come up with his idea by then, you'd have to show Lucas met him or something.

    4. The consistent pattern of right wing wack jobs, of whatever strip,is that they just make it up as they go along. Facts matter not a whit. I will leave it to some future Soros biographer to tell the whole story.

      Unlearningecon, below, says that Keynes actually had the ideas. I can accept that. How about you?

  8. The Lucas Critique was, of course, stated far more eloquently by Keynes and Phillips before Lucas himself.

    1. would appreciate citations, if available



  9. Anonymous9:57 AM

    The change in behavior in response to policy can be a good thing as Keynes noted for depressions with slack demand and high unemployment. If the Government policy changes to hire labor, then labor has more money to spend which increases demand and convinces business to also hire more labor to meet the rising demand. Business sees the change in policy and acts in response. We know this, we have plenty of historical data, yet there is no political will to address the unacceptably high unemployment levels we have today.

    In a previous era, we had a Fiscal policy and a Fed that took the unemployment mandate seriously. Now we have Fiscal policy that is more concerned with defunding public spending on the middle class than JOBS. We have a Fed that is singularly focused on maintaining ridiculously low inflation rates and completely ignores their unemployment mandate. Business expects that under current policies, demand will only increase very slowly if at all and they respond by not hiring workers.

    Our high unemployment is not the fault of the models. It is the lack of political will and politicians who do not place enough value on jobs.

    jonny bakho

  10. I think all this discussion shows a confusion regarding the difference between a model and the real world.

    I like New-Keynesian models. I think there is evidence of some price stickiness,and I keep quoting Lee and Huang's paper because I like their hypothesis that even if individual firms change their prices rather frequently, with multiple stage of production the overall adjustment process may take time. By the way, Lucas liked the idea too when Liu told him about it in person. Morever, let us not forget that money is not neutral in Lucas's model! But that model has some interesting implications even for new-Keynesians like myself. If by trying to exploit the non-neutrality of money you make price and wage setting too costly for firms and workers, they will find ways of dealing with this cost thus rendering your policies ineffective.

    So how should someone use economic models to understand the world and formulate policy? Of course you shouldn't choose one model and use it as if it is a perfect representation of the real world. What you should do is consider a variety models, get insights from each, and then decide which insights seem more relevant given your circumstances (which model's assumptions seem to be more relevant to the situation you are in). Yes, judgment calls have to be made. Sorry boys and girls, in social sciences you have to be willing to stick out your neck once in a while. But then again, the same is true, for example, about medical reserarch on the effects of second-hand smoking.

    1. It just seems to me that the more judgment calls you have, the less confident you should be about the results. Keep adding judgment calls, and eventually you're nothing more than an old guy spouting his prejudices in the form of folk wisdom. Macroeconomics, in my opinion, has false pretensions of certainty.

    2. But does it really? Most well-known macroeconomists I have interacted with (including Lucas, Prescott, Friedman, and Sargent) are very modest for that same reason. In fact, it should be that way for all economists. For example, my friends doing experimental economics were always cautious about extrapolating results obtained with a small number of half-baked college students "playing" with small amounts of money to the general population. But this does not mean that their findings are not worth considering. How important is hyperbolic discounting if people can pre-commit? Doesn't this require a judgement call? Of course it does. It needs to be an educated call, making use of the data. But unless the data are very conclusive people will see what they want to see, regardless of whether the issue is the effectiveness of monetary policy, climate change, or second-hand smoking (just google the controversy surrounding the Engstrom and Kabat study). At least this is less true among scientists than it is for the general public (or we wouldn't still be debating evolution).

      INo science can offer the objectivity that you strive for. Physics, not economics, is what Feyerabend brought as an example when he advocated scientific anarchism. My view (consistent with Kuhn) is that there are many things we cannot be sure of, but this does not mean that anything goes. As I concluded in a recently accepted paper on the impact of economic freedom in Latin America, in the end policy-makers may have to learn by trial and error.

      Finally, Krugman begins his book Peddling Prosperity (2004) by making this exact point. He starts by talking about how an Indian economist once explained his personal theory of reincarnation to his graduate economics class. "'If you are a good economist, a virtuous economist,' he said, 'you are reborn as a physicist. But if you are an evil, wicked economist, you are reborn as a sociologist.'"
      Krugman then continues to say:
      "A sociologist might say that this quote shows what is wrong with economists: they want a subject that is fundamentally about human beings to have the mathematical certainty of the hard sciences . . . . But good economists know that the speaker was talking about something else entirely: the sheer difficulty of the subject. Economics is harder than physics; luckily it is not quite as hard as sociology."

    3. Well, I don't know if science has "objectivity" or not, but physics works really well, and the physics profession judges the validity of a theory on how well it matches the data. I don't think one can really say either of those things for macro. Yes, macro is inherently a lot harder, but I think that our response to that inherent hardness should be humility, admission of ignorance, and working on small simple problems, instead of making a million business-cycle models that don't work...But yeah that is just my opinion.

    4. As somone who does not work on business cycle models, I would say that the key word is tolerance. I learn from business cycle models and experimental studies, from micro models based on superhuman agents that equate the MRS of thousands of goods and services with their relative prices (isn't this standard demand theory?), and from computational micro models that allow consumers to choose from a limited set formed by custom and experience. Perhaps embracing diversity of methods rather than attacking what is different would serve us all better...and help each of us experience a more pleasant professional career. If one thinks that a business cycle model does not work, they should try to build a model that does work (or find some other way to contribute to the discussion) and let their work do the talking. The world is full of people sitting at the side-line with a hot-dog in one hand and a beer in the other, criticizing those who have earned the right to sweat in the field. God knows we don't need any more!

      P.S. As far as I know, (macro) economists also look at the data to evaluate their theories, or Lucas wouldn't have bothered to conduct and publish a test of his own. However, and that was Krugman's point, the data economists use speak less loudly. But you should read Feyerabend's reference to renormalization in quantum mechanics.

    5. I learn from business cycle models and experimental studies

      "Learn" is an interesting can "learn" wrong things from papers. For example, suppose an experiment is confounded by the experimenter, but nobody bothers to check very carefully, so the result gets published, and everyone reads it and "learns" the spurious result.

      You say we need to be tolerant; I say we need to be tough. Type I errors are just more grievous than Type II errors (and I am speaking in a general sense), because there are a lot more wrong ideas than right ideas in the Universe. We need good, strict, tough methods of throwing away bad ideas and bad results. My beef with macro, in a nutshell, is that I think it is too tolerant and not tough enough.

      Perhaps embracing diversity of methods rather than attacking what is different would serve us all better...and help each of us experience a more pleasant professional career.

      I'm a little dense so help me out...that's a threat, right?

      Well, whatever. Look, I am all for letting a thousand flowers bloom when it comes to methodologies, theories, approaches, etc. But then I think you have to stamp 90% of those flowers underneath an iron-shod bootheel of skepticism. I don't think we're in this business to all pat each other on the back, and publish each other's papers without checking, and then say "No one outside the country club has a right to criticize what the people in the club do (but please keep sending checks, thanks!)". I mean, I like patting people on the back, but this is science. Or at least, it should be. We're trying to figure out what's really, actually going on in the world, in order to increase humankind's power to control our universe.

    6. Also, just out of curiosity, CA, what do you do? Are you an econ prof? Does "CA" mean you live in California?

    7. So are you saying that we have learned nothing from Lucas or Prescott? I don't agree. Empirical evidence suggests that they got some things right, even if they were wrong on other (e.g., I think technology shocks are important, but I don't agree that the best way to model their impact on employment is by assuming market-clearing. Or, people may adjust their behavior in response to monetary policy, but only when the cost of doing business-as-usual becomes high enough to make it worth their while). You can't get there from reading one paper. You have to read a lot with an open mind, then look at the (ever-changing) data.

      Of course what I wrote about "pleasant careers" was NOT a threat, just a well-intended advice by someone who has been in the game a bit longer (I am still an Assistant Professor, but I have moved a lot). You think you are not a member of the club with a University of Michigan Ph.D., try holding a Ph.D. from Clark like I do, lol. Having said that, very rarely have I had a paper rejected (and I have gotten A LOT of rejections) for which there was no ground for rejection. One thing I have learned is that the big boys will contemplate any idea regardles of where it comes from or how contrary it goes to what they know, provided that you make a convincing-enough argument. This is not to say that there are no biases, just that they are not THAT impenetrable.

      CA are my initials (Consantine Alexandrakis). I am at Hofstra University, on Long Island, not too far from your new employer. In fact I was hoping that if your time and mine (one child, second on the way) permits, we could have some of these discussions in person. Sorry if often my posts are filled with typos or don't make much sense. Writing in-between tasks (revising manuscripts or making dinner for the family)definitely takes a toll.

    8. Further clarification: by "serve us all better" I mean the profession. While it is healthy to have methodological concerns, how you have the debate in public forums is of huge importance. There are enough people out there who, despite all evidence, think that the world is flat, the U.S. is on the downward side of the Laffer curve, the gold standard is a good idea, and picking stocks is a good investment strategy (the overconfidence that I think you test in one of your papers). We should not make it easier for what Krugman calls zombie ideas to flourishing, by undermining whatever little we do know as economists through our continuous bickering.

    9. In fact I was hoping that if your time and mine (one child, second on the way) permits, we could have some of these discussions in person.

      Definitely! My email is'll have time to meet up after 9/1...let's have dinner!

      Of course what I wrote about "pleasant careers" was NOT a threat, just a well-intended advice by someone who has been in the game a bit longer

      Haha, no worries.

      My situation is that I have never been a macroeconomist, I just learned a lot of macroeconomics in grad school. I decided I didn't like the methodology and culture of the macro field, so I decamped to finance/experimental/behavioral, which was really where I was always headed in the first place. I have very few problems with the way financial economics is done, so I think I'll be a lot happier there, and probably piss fewer people off as well.

      So are you saying that we have learned nothing from Lucas or Prescott?

      I think we learned a lot from Lucas. As the first sentence of the original post indicates, I think the Lucas Critique is 100% correct, and is a great insight (note that it's an insight about how ignorant macroeconomists are!). I also like the Lucas Islands Model a lot more than many people seem to. As for Rational Expectations, I think it was a good idea, but I think Lucas didn't seem to be concerned enough when RE models kept failing to fit the data (as evidenced by when he and Prescott asked Tom Sargent to stop testing the models!).

      As for Prescott, I can't think of a single result of his that doesn't involve some "anti-learning", though I think the Equity Premium "Puzzle" led to a lot of fruitful research. I am very very down on RBC models, and also fairly down on the result about European labor hours being a function of taxes. I confess to being pretty exasperated with basically everything I read by Prescott; his essay "Theory Ahead of Measurement" especially annoyed me. So make of that what you will...

      There are enough people out there who, despite all evidence, think that the world is flat, the U.S. is on the downward side of the Laffer curve, the gold standard is a good idea, and picking stocks is a good investment strategy (the overconfidence that I think you test in one of your papers). We should not make it easier for what Krugman calls zombie ideas to flourishing, by undermining whatever little we do know as economists through our continuous bickering.

      I agree with that. Not knowing the true craziness that was out there (goldbugs, "Austrian" Ron Paul people, etc.), I have often held a distorted picture of where the debate really stands at the national level. It's worth remembering that the wrongest-sounding thing I read by Ed Prescott is certain to be far, far more reasonable than 99.9% of the comments on Zero Hedge...

  11. To satisfy the Lucas Critique (which in some cases may be very weak, or slow), it's not just necessary that agent behavior be invariant to a change in policy. It could also be the case that the agents' behavior will, in fact, change in response to the policy, but that change is figured into the model.

  12. Anonymous5:15 AM

    Here's my Grey Law: if there is any economic "rule" which can be used to "make money", people will change their behavior to use the rule to make money, and this changed behavior will invalidate the rule (at some time).

    Human action, because of Free Will, will never follow "laws" like physics.

    On models, one problem is the variables chosen For instance, almost no models use "YoY % change in Net Worth" as a variable. Since for 60 years there hadn't been such big changes. Yet in the 2006-2008 (-2012?) period, there has been a huge drop in median (and average) Net Worth. And the "money" that people have is not just job income, but also saved asset values.

    And what if the important relationship is of the form YoY% + [(10 * YoY%)^2] so that at the 10% change level the square becomes 1, and if it's 20%, the square becomes 4. The point being that some usually ignored variable becomes dominant after some threshold is passed.

    Biology, including medicine and environment, more than physics should be better scientific model. Threshold effects are far more prevalent there than in physics.

    Climate models are also subject to the changing variable importance issue.

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  14. Very true. You can use your model to help solve the problem but if it doesn't work, then a new model or strategy should be made to help solve our economy's problem.

  15. Anonymous2:35 PM

    My experience has been this: I myself subscribe to lots of methodological critiques of mainstream macro. I believe there is quite a lot of good work and papers with value, even if it's surrounded by loads of crap. I've found, though, when I submit a paper to a journal and the referees don't like it for whatever reason, even clearly very mainstream referees will often resort to heterodox-ish, high-minded methodological critiques of my paper, which seemingly apply to every other macro paper... Better to write that "you didn't really test your model" or "you didn't prove your model is the mechanism behind your empirical finding" than "I don't like the policy implications of your paper"...

    Not saying my papers are the best thing ever, but how many empirical papers prove that the model they are using is the only one which can account for an empirical finding? Doesn't the weierstrass polynomial approximation theorem suggest there's always an infinite number of such models within an epsilon of describing any set of data?

    Whether or not your model sounds like a plausible explanation of your empirics, and whether the implications are interesting are all judgment calls. Which means the judgments get determined by personal and political biases, and whatever quality signals you can provide (e.g., this guy has a phd from a famous place and this model is complicated looking so this guy must be smart, but familiar enough to me, the referee, that I don't feel stupid).

  16. Tygerrr10:17 AM

    What about ISLM?

    Look, this is from someone with no educational background in economics whatsoever, but I live in an economy that just isn't working for me and billions of others earth-wide. I appreciate you making it so easy to comment here, Noah, and I don't mean to demean what is, to me, a highly technical discussion. That said, we mere participants are trying to make enough sense of economics to avoid getting screwed all the time by politics. Can ya'll be more helpful, please?

    I got here through a link from the Krugman blog. I go there because he presents economics accessibly for the unschooled, and because I'm of a liberal bent and need comfort sometimes. Seems to me ISLM has worked well over time. What's your collective critique of it?

  17. Deniz4:01 PM

    Here is the response of Smets and Wouters (and Gali) to the criticism of Chari, Kehoe and McGrattan (2008):

    Question: Does this model (GSW) satisfy Lucas Critique now?

    Frankly, I just found this study and couldn't read yet. I do not know the answer for the moment...