Bring out the important issues on which Lucas criticizes Keynesian macroeconomics. To what extent the New-Keynesian economists have accepted these criticisms?

 In an interview Lucas said the following words:

“I think Keynes’s actual influence as a technical economist is pretty close to zero and it has been close to zero for 50 years. Keynes was not a very good technical economist. He did not contribute much to the development of the field.

Keynes’ influence was more political, is more an image of what sort of things an economist should be doing and what kind of life an economist should live.” Lucas argued that Keynesian economics required remarkably foolish and short-sighted behaviour from people, which totally contradicted the economic understanding of their behaviour at a micro-level. 

In the view of Lucas Keynesian orthodoxy has turned redundant not only from economic policy point of view but also from theoretical and methodological points of view. Here are the following criticisms of Keynesian theory brought by Lucas:

. Ignorance of equilibrium discipline: Lucas criticised Keynesian economics by saying that Keynes discarded equilibrium discipline.

Lucas had opinion that every economist should abide by this equilibrium disciple while structuring a theory. In fact, equilibrium disciple has two postulations i) that agents act in their own self interest and ii) that markets clear. According to Lucas by betraying this equilibrium discipline, Keynes gave an example of bad social science: an attempt to explain important aspects of human behaviour without reference either to what people like or what they are capable of doing.

. Phillips curve controversy: Keynesians defended the stable Phillips curve allowing for a trade-off between inflation and unemployment.

Lucas criticised this. He said there is no trade-off between inflation and unemployment even in short-run if rational expectation hypothesis is assumed. Keynesians believed on adaptive hypothesis.

. Lucas critique: Nobel Prize winner economist Robert Emerson Lucas Jr. states that there are many issues or topics in Economics about which the knowledge of economists is either limited or zero. 

Economists cannot be completely confident while assessing the effects of alternative policies. Therefore, economists should exercise a big caution when evaluating or assessing a policy and giving advice. Lucas’ focus revolves around expectations made by people. He says that expectations play crucial role in economic behaviour of economic agents.For example: Firms invest keeping in view the expected profitability and consumers spend keeping in view their expected income.

Therefore, policymakers should give a great weightage to the expectation made by people in response to a given policy. Lucas states that traditional methods of policy evaluation do not adequately consider this impact of policy on expectations. He criticised such traditional methods and his criticism got famous as Lucas critique. 

The sacrifice ratio is one of the best examples of Lucas critique. Sacrifice ratio means how many per cent GDP will decline if inflation is to be reduced by one per cent. Sacrifice ratio measures the cost of reducing inflation. Since, the measures of sacrifice ratio are large, hence, some economists argue that policy-makers should learn to live inflation instead of incurring large cost of reducing it.

However, the supporters of rational expectation hypothesis argue that data of sacrifice ratio are not reliable because they are subject to Lucas critique. This is so because such data are based upon adaptive expectation approach, i.e. people expect a variable on the basis of its past trend.

Although, adaptive expectation may be suitable in some circumstances, yet if the policymakers make a credible change in a policy, workers and firms setting wages and prices will rationally respond by adjusting their expectations of inflation appropriately. This change in inflation expectations will quickly alter the short-run trade-off between inflation and unemployment. As a result, reducing inflation can potentially be much less costly than appears in data in sacrifice ratio.

Lucas writes in his”Econometric policy evaluation: A critique” Carnegie-Rochester Conference Series on Public Policy that”Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision-maker, it follows that any change in policy will systematically alter the structure of econometric models.” 

Expectations played a major role in Keynes’ theory of the determination of aggregate output and employment in market economies in the short-run. Expectations about future yields on investment projects underlie ‘the marginal efficiency of capital’ schedule.

However, the volatile nature of these expectations plays a major role in explaining why investment expenditure and therefore output and employment in market economies are subject to fluctuations.

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