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Model 2 and the Lucas critique - Coggle Diagram
Model 2 and the Lucas critique
In model 1 we had assumption for target real wage, in model 2 we suppose wage contracts span multiple time periods
level of output in this model depends on monetary parameters
without deriving variance we can see that the terms will depend on the parameters of the policy rule
The variance as well as level of prices will be affected by monetary policy behaviour
therefore PIP in this model doesn't hold
Policy is ineffective
Why is it that policy is ineffective?
Agents cannot accurately forecast 2 periods ahead
Cannot be sure of the shock term in 2nd period, to which monetary authority will respond
therefore money surprise in non zero
wages can therefore deviate from equilibrium
this creates scope for policy to affect output by responding to parts of next period shocks which can't be seen or predicted
Policy ineffectiveness
depends on
perfect market clearing
RE
Models in which PIP does not hold assumes:
2 period wage contracts
price stickiness
this can be argued is not optimal for agents
Lucas critique
ineffectiveness of result depends on how sticky wages are and perfect market clearing
Economics case
Identifies problem in econometric work due to RE, nature of policy being operated by government/monetary authority affects expectations
Naive to try to predict the effect of a change in policy based entirely on past data
people will behave differently in expectation of that is announced
hard to predict how people will react
In the AD/AS model
What is true relationship between Y&M in this model?
in period t-1 private agents can see the t-1 period output gap which is what monetary authority reacts to
to find relationship substitute and solve
for lon run effect on y of permanent, announced and understood change in m, set yt-1=yt
collect terms and differentiate
End equation shows true relationship between y&m when
no account is taken of expectations
from this find the money multiplier
Take partial derivates of Y & M
Conclude that money affects output, although we know that in this model it does not so what's going on?
Whats going on?
Change in m seems to be
non zero
This is because the model is mis-specified (no rational/other expectations)
effect depends on value of β which reflects the impact that policy had over period used for regression
Old fashioned economists:
don't recognise importance of expectations
will regress y on m and other variables to find effects of monetary policy on Y
Model 1: change in RF
Monetary authority has imperfect monetary control so introduce shock value Z