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The Lucas critique and the stability of empirical models

✍ Scribed by Thomas A. Lubik; Paolo Surico

Publisher
John Wiley and Sons
Year
2010
Tongue
English
Weight
143 KB
Volume
25
Category
Article
ISSN
0883-7252

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✦ Synopsis

Abstract

This paper reconsiders the empirical relevance of the Lucas critique using a DSGE sticky price model in which a weak central bank response to inflation generates equilibrium indeterminacy. The model is calibrated to capture the magnitude of the historical shift in the Federal Reserve's policy rule. Using Monte Carlo simulations and a backward‐looking model of aggregate supply and demand, we find that shifts in the policy rule induce breaks in both the reduced‐form coefficients and the reduced‐form error variances. When the instability of the reduced‐form error variances is accounted for, the Lucas critique is found to be empirically relevant. Copyright Β© 2009 John Wiley & Sons, Ltd.

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