Adaptive Expectations, Underparameterization and the Lucas Critique

Abstract

A striking implication of the replacement of adaptive expectations by Rational Expectations was the "Lucas Critique," which showed that expectation parameters, and endogenous variable dynamics, depend on policy parameters. We consider this issue from the vantage point of bounded rationality, where for transparency we model bounded rationality by means of simple adaptive expectations. We show that for a range of processes, monetary policy remains subject to the Lucas critique. However, there are also regimes in which the expectation parameter is locally invariant and the Lucas critique does not apply.

Keywords: Lucas critique, expectations, underparameterization, bounded rationality, learning.

JEL Classification: E52, E31, D83, D84