Problem 4: The Keynesian-RBC-New Keynesian Evolution (15 points). Here you will
ID: 1125655 • Letter: P
Question
Problem 4: The Keynesian-RBC-New Keynesian Evolution (15 points). Here you will briefly analyze aspects of the evolution of macroeconomic theory over the past 35 years. Address each of the following. a. (5 points) Describe briefly what the Lucas critique is and how/why it led to the demise of (old) Keynesian macroeconometric models. b. (5 points) In writing down utility functions and production functions for use in "RBC-based" macro models, the assumed functions are typically "estimated" using data (i.e., a common assumption is the logarithmic utility function we have often used, based on some statistical evidence that is consistent with observed microeconomic and macroeconomic evidence). Is this practice subject to a "Lucas- type critique?" Briefly explain why or why not? c. (5 points) Briefly define and describe the neutrality vs. nonneutrality debate surrounding monetary policy. And, as specifically as you can state, which type of shock does this debate concern? (Your TOTAL response should not exceed 40 words.)Explanation / Answer
a.
Robert Lucas thought that existing Macro-econometric models are irrelevant for policy evaluation. According to him there exist a conflict between, economic theory and econometric practice. He was of opinion that models that dint considered adjustment of human behavior can’t be used for policy evaluation, because if we try to use them people may change their behavior till models no longer worked. This makes old Keynesian models irrelevant to policy evaluation in present times.
According to Lucas when evaluating different policies, the old theory of economic policy, tries to predict the effects of change based on fixed estimated parameters. He argued that when economic policy changes, the structure of the relationships between economic variables shifts due to changes in people’s behavior. He claimed that it is naive 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.
C.
Neutrality vs Non-Neutrality:
Neutrality: According to this theory Increase or decrease in money supply do not affect real variables (i.e., consumption or GDP) in the economy but only affects nominal variables (price levels)
Non-neutrality: The New Keynesian view holds that changes in money supply do affect real variables (output, GDP, consumption), because prices take time to adjust (are “sticky”).