Editing Macroeconomic model (section)

====The Lucas critique of empirical forecasting models====
{{Main|Lucas critique}}

Econometric studies in the first part of the 20th century showed a negative correlation between inflation and unemployment called the [[Phillips curve]].<ref>{{Citation |last=Phillips |first=A. W. |year=1958 |title=The relationship between unemployment and the rate of change of money wages in the United Kingdom 1861-1957 |journal=[[Economica]] |volume=25 |issue=100 |pages=283–299 |doi=10.2307/2550759|jstor=2550759 }}</ref> Empirical macroeconomic forecasting models, being based on roughly the same data, had similar implications: they suggested that unemployment could be permanently lowered by permanently increasing inflation.  However, in 1968, [[Milton Friedman]]<ref>{{Citation |last=Friedman |first=Milton |year=1968 |title=The role of monetary policy |journal=[[American Economic Review]] |volume=58 |issue=1 |pages=1–17 |jstor=1831652 |publisher=American Economic Association }}</ref> and [[Edmund Phelps]]<ref>{{Citation |doi=10.1086/259438 |last=Phelps |first=Edmund S. |year=1968 |title=Money wage dynamics and labor market equilibrium |journal=[[Journal of Political Economy]] |volume=76 |issue=4 |pages=678–711 |s2cid=154427979 }}</ref> argued that this apparent tradeoff was illusory.  They claimed that the historical relation between inflation and unemployment was due to the fact that past inflationary episodes had been largely unexpected.  They argued that if monetary authorities permanently raised the inflation rate, workers and firms would eventually come to understand this, at which point the economy would return to its previous, higher level of unemployment, but now with higher inflation too.  The [[1973–75 recession|stagflation of the 1970s]] appeared to bear out their prediction.<ref>Blanchard, Olivier (2000), op. cit., Ch. 28, p. 540.</ref>

In 1976, [[Robert Lucas Jr.]], published an influential paper arguing that the failure of the Phillips curve in the 1970s was just one example of a general problem with empirical forecasting models.<ref>{{Citation |doi=10.1016/S0167-2231(76)80003-6 |last=Lucas |first=Robert E. Jr. |year=1976 |title=Econometric Policy Evaluation: A Critique |journal=Carnegie-Rochester Conference Series on Public Policy |volume=1 |pages=19–46 |url=http://www.dpipe.tsukuba.ac.jp/%7Enaito/teaching_web/public_economics_2013_web/Lucas_critieque_1983.pdf }}</ref><ref>{{cite book |first=Kevin D. |last=Hoover |chapter=Econometrics and the Analysis of Policy |pages=[https://archive.org/details/newclassicalmacr0000hoov/page/167 167–209] |title=The New Classical Macroeconomics |location=Oxford |publisher=Basil Blackwell |year=1988 |isbn=0-631-14605-9 |chapter-url=https://archive.org/details/newclassicalmacr0000hoov/page/167 }}</ref> He pointed out that such models are derived from observed relationships between various macroeconomic quantities over time, and that these relations differ depending on what macroeconomic policy regime is in place.  In the context of the Phillips curve, this means that the relation between inflation and unemployment observed in an economy where inflation has usually been low in the past would differ from the relation observed in an economy where inflation has been high.<ref>Blanchard, Olivier (2000), op. cit., Ch. 28, p. 542.</ref>  Furthermore, this means one cannot predict the effects of a new policy regime using an empirical forecasting model based on data from previous periods when that policy regime was not in place.  Lucas argued that economists would remain unable to predict the effects of new policies unless they built models [[Microfoundations|based on economic fundamentals]] (like [[preferences]], [[production function|technology]], and [[budget constraint]]s) that should be unaffected by policy changes.