The Lucas critique cuts both ways

I’m occasionaly asked how NGDP level targeting would have performed in a specific historical case, such as 1981 or 2023. The usual worry is that when NGDP is well above trend, a policy of level targeting might require a highly contractionary monetary policy, triggering a recession.

Here it’s worth recalling the Lucas critique (from Wikipedia):

The Lucas critique argues that it is naïve 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.

The problem with trying to evaluate how NGDPLT would have done in a specific case is that if the policy had been in effect during that period then the condition of the economy would have been much different. Thus if NGDPLT had been in effect during the 1970s, then it’s unlikely the economy would have become so overheated by 1981. Indeed the whole point of NGDPLT is to prevent the sort of inflationary policy we had during 1965-81.

If NGDPLT had been adopted last year, it’s unlikely that the Fed would have tried to push the economy back to the pre-2020 trend line, as that would have triggered a deep recession. They would have started from a new trend line. On the other hand, if NGDPLT had been adopted in 2020, then monetary policy would have been far tighter in 2021, and the economy never would have become so overheated.

The Lucas critique is often viewed as a cautionary tale—something that makes it likely that policy innovations will disappoint. In the case of NGDPLT, however, the Lucas critique suggests that the policy might be more effective than it appears at first glance. Instead of thinking about how NGDPLT would deal with all of the “shocks” we’ve experienced over time, think about how NGDPLT would have prevented those shocks from occurring in the first place.

Off topic: Conor Sen has a good piece on how the economy seems to be re-accelerating:

Slower inflation was supposed to be a sign that the economy was cooling, all part of the Federal Reserve’s plan for higher interest rates to restore balance to the economy. For a while, things looked on track. But since the middle of January there’s an argument that economic activity is picking up again, despite monetary policy being tighter than at any point in years. . . .

Frequent readers of mine will note that this is a walk-back of a bias I’ve had for the past few months. I started worrying about a labor-market slump in early November as the unemployment rate rose and worker income growth slowed. Earlier this month, I described the recovery in some cyclical parts of the economy as akin to a “dead cat bounce” that would eventually be swamped by high interest rates; it’s not unreasonable for something like existing home sales to climb when transactions were at their lowest level since 2010.

Frequent readers know what I’m about to say. At no time in the past few years has monetary policy been “tight”. Indeed it’s been generally expansionary, which is why NGDP growth remains excessive.



17 Responses to “The Lucas critique cuts both ways”

  1. Gravatar of dtoh dtoh
    2. March 2024 at 16:42

    My two remaining questions about NGDPLT are:

    1. If you are significantly off trend (e.g. after Covid), do you really want to go back to trend, or should you reset the trend line a bit.

    2. Will any target of NGDP get you the same RGDP over the long run. I.e. is there some inflection point at which any change in the target goes from all Real Growth to all inflation. If not, how do you pick the optimal target.

  2. Gravatar of ssumner ssumner
    2. March 2024 at 16:49

    1. If you were already doing NGDPLT, then yes, you’d want to go back to trend. But the Fed was not doing NGDPLT, so they should try to set a new trend line and start targeting that new line.

    2. The Natural Rate Hypothesis says no effect on RGDP in the long run. This theory is an approximation of reality, which holds pretty well for a country like the US. If you had hyperinflation or severe deflation then there might be some long run effect.

  3. Gravatar of dtoh dtoh
    2. March 2024 at 17:30


    I’ve always been a little skeptical of both.

    1. Seems to me if you get far enough off trend, there are some practical limits to growth outside of monetary policy. Also if for example, you could grow 8% real in one year to catch up, why couldn’t you just keep growing at 8%.

    2. Not sure I buy this one either. Given sticky wages/prices, a little more inflation allows for the economy to make faster adjustments, which would I think increase real growth.

  4. Gravatar of Todd Ramsey Todd Ramsey
    3. March 2024 at 08:07

    Most of us are sold on the idea of an NGDP security market.

    Commenters, how do we move from talk to actually getting a security created? Ken Duda, you are a highly effective person. Any ideas?

  5. Gravatar of Travis Allison Travis Allison
    3. March 2024 at 10:02

    The reasoning of the Conor Sen piece leaves a lot to be desired. He uses a lot of economic writing cliches: “confidence”, “cut rates…boost to rate sensitive parts of the economy.” It reminds me of the old New Yorker Mankoff cartoon:

  6. Gravatar of ssumner ssumner
    3. March 2024 at 12:29

    Todd, I think the Fed has to do this.

  7. Gravatar of William Peden William Peden
    4. March 2024 at 03:30


    There are loads of factors that could lead to departures from the NRH. Friedman acknowledged at least two: hysteresis from a preceding macroeconomic disaster and the deadweight loss from the inflation tax on the monetary base. The point is that there isn’t great evidence that these make a big difference, such that a country with a trend inflation rate of e.g. 2% or 4% will do better than a country with price stability or mild deflation.

    I think that George Selgin’s pamphlet on these issues still holds up really well after nearly 30 years of subsequent research:

  8. Gravatar of spencer spencer
    4. March 2024 at 04:47

    The FED wouldn’t have been able to target N-gDp during the Great Inflation unless they changed their operating procedure. The banksters simply usurped the trading desks’ “open market power”.

    The effect of tying open market policy to a fed funds bracket was to supply additional (& excessive) legal reserves to the banking system when loan demand increased.

    Since the member banks had no excess reserves of significance, the banks had to acquire additional reserves to support the expansion of deposits, resulting from their loan expansion. If they used the Fed Funds bracket (which was typical), the rate was bid up & the Fed responded by putting though buy orders, reserves were increased, & soon a multiple volume of money was created on the basis of any given increase in legal reserves.

  9. Gravatar of spencer spencer
    4. March 2024 at 05:06

    re: “the economy seems to be re-accelerating:”

    Retail MMMFs are nonbanks. Mises has it right:

    “The definition of M2 includes money market securities, mutual funds, and other time deposits. However, an investment in a mutual fund is in fact an investment in various money market instruments. The quantity of money is not altered as a result of this investment; the ownership of money has only changed temporarily. Hence, including mutual funds as part of M2 results in the double counting of money.”

    see: “Correlations and the Definition of the Money Supply”
    October 19, 2023

    The FED’s technical staff doesn’t know a debit from a credit. Just like MSB deposits were misclassified (included in the tabulations of the money stock), from 1913 to 1980, MMMFs deposits should not be classified in M2.

    Leland J. Pritchard
    First published: March 1954

    So, O/N RRPs are misrepresented. Thus, the conventional wisdom is wrong:

    “O/N RRPs do not affect the size of the money stock, but they do affect its composition1. When counterparties lend cash to the Fed, they reduce the amount of reserve balances on the liability side of the Fed’s balance sheet and increase the amount of reverse repo obligations1. This means that there is less money available for lending in the private market, which can put upward pressure on interest rates”

    According to the Federal Reserve Bank of Chicago’s “Modern Money Mechanics”:

    “If the buyer of a reverse repo or a security sold by the Fed is a nonbank (which 90% of RRPs are), and pays for the purchase using its bank account, the money supply is directly affected”.

    Both money and reserves are increased. The FED has been supplying liquidity to the markets.

  10. Gravatar of dtoh dtoh
    4. March 2024 at 06:01


    1. There’s not going to be much evidence (at least statistically significant evidence) regarding this issue so I think the lack of evidence is not a valid argument.

    2. Hysteresis can be pretty long lasting so that argues for a higher NDGP target.

    3. Fundamentally I think you can posit that regardless of hysteresis, financial asset prices are less sticky than wages and therefore a high target will lead to more rapid adjustment.

  11. Gravatar of Todd Ramsey Todd Ramsey
    4. March 2024 at 06:06

    “Todd, I think the Fed has to do this.”

    Won’t it have to be Treasury, replacing some of the current debt issues with NGDP securities?

    The NGDP security market has to be massive. Otherwise finance pros will game the NGDP market in order to make money in other, bigger markets.

  12. Gravatar of spencer spencer
    4. March 2024 at 06:36

    The FED’s technical staff conflates micro with macro. Thus, they can’t differentiate how the system works. From the standpoint of the system, banks don’t lend deposits. Bank-held savings have a zero payments velocity.

    See: BANKS DON’T LEND MONEY ( Dr. Richard Werner

    That’s the basis for Dr. Philip George’s “The Riddle of Money Finally Solved”

    There’s been a “sea change”. The composition of the money stock has reversed secular stagnation, the impoundment of savings in the banks.

    Link: George Garvey:

    Deposit Velocity and Its Significance (
    “Obviously, velocity of total deposits, including time deposits, is considerably lower than that computed for demand deposits alone. The precise difference between the two sets of ratios would depend on the relative share of time deposits in the total as well as on the respective turnover rates of the two types of deposits.”

    The ratio of transaction deposits to gated deposits has reversed by 18%. That has raised the growth of N-gDp.

  13. Gravatar of William Peden William Peden
    4. March 2024 at 09:41


    1. A lack of evidence for particular departures from the NRH, given at least some work in pursuit of that, is positive evidence for the NRH. I agree it’s far from conclusive evidence and I agree that’s the nature of macroeconomics.

    2. As I understand it, hysteresis is supposed to be about the permanent effects of a change in NGDP (or money supply etc.). This is one argument for gradualism in reducing inflation given high inflation expectations, at least where that’s an option; conversely, it’s an argument for rapid returns to pre-existing NGDP trends. And I can see it as an argument against large persistent variance in NGDP. However, a higher NGDP target is about the rate of change. I don’t see the relevance of a rate of change to either variance or changes in levels per se.

    3. “Fundamentally I think you can posit that regardless of hysteresis, financial asset prices are less sticky than wages and therefore a high target will lead to more rapid adjustment.”

    I don’t follow. Adjustment to price changes?

  14. Gravatar of ssumner ssumner
    4. March 2024 at 10:00

    People seem to have short memories, as I’ve gone over the NRH dozens of times. To reiterate, it’s just as likely that if the NRH is false then we should lower the NGDP target, and thus reduce the real tax rate on capital income.

  15. Gravatar of dtoh dtoh
    4. March 2024 at 13:47

    Just like there is monetary offset to fiscal policy, there can be legislative offset to monetary policy.

    There is no reason to think that the legislated rates of taxation on capital income don’t incorporate expectations of likely future inflation.

    Monetary policy that reduced long term inflation expectations would also like result in higher nominal rates of taxation on capital income.

  16. Gravatar of stoneybatter stoneybatter
    5. March 2024 at 07:43

    Scott, you said “I think the Fed has to do this [create a NGDP security market].”

    Given Treasury already issues TIPS, do you not think it is more feasible/likely that they could issue securities indexed to NGDP in the same way as TIPS? Then it would be easy to calculate expected NGDP, albeit with the usual qualifications about liquidity between NGDP-linked bonds and nominal Treasuries.

    That seems easier to achieve than the Fed creating an entirely new market.

  17. Gravatar of ssumner ssumner
    5. March 2024 at 09:45

    dtoh, Maybe, but given the gridlock in DC, how long will that take?

    Stoneybatter, If the Fed’s not making the market, it would lack liquidity. There’s little interest in NGDP securities unless the Fed trades them.

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