Lucas critique

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The argument that the government cannot take the decision rules of private agents as fixed when it chooses policy but instead should take account of how decision rules change as policy changes. An alternative way to describe the critique is as follows. Assume the government conducts an econometric analysis to determine how investment by firms has, in the past, depended upon the corporate tax rate. The Lucas critique then asserts that the results of the econometric analysis will not correctly predict future investment if the government changes its corporate tax policy. This is because firms will adapt to the new policy and the relationship between investment and the corporate tax rate will change.

Subjects: Economics.

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