PART C
From Robert Lucas’s work, the Lucas critique was developed for macroeconomic policymaking. As a result of the Lucas critique institutions now adopt models with optimizing foundations and rational expectations. According to the Lucas critique, models that do not allow the adjustment of human behavior should not be used in policymaking. The Lucas critique argues that the development of policies without taking into account any structural changes such as government changes may result in the adoption of policies that have no impact. This was due to peoples’ change in behavior which led to the inaccuracy of these models which implied that they could not work. The critique argues that basing macro-economic policies on analysis of relationships observed aggregated historical data. From this data, it is not possible to model the behavior of humans. The behavior of people changes depending on the situation that they are in and other factors. This implies that behavior varies from person to person. The solution to this critiques was the adoption of models that included behavior as a variable in decision making. From the adoption of the behavior variable, the welfare of the employees is catered for. This is a result of the addition of behavior as a variable which implies that any institution must make its employees happy before any successes can be attained.
In the 2008 financial crisis which resulted in the recession is an example of what Lucas critiqued. The whole process which led to the adoption of policies such as qualitative easing can be reviewed based on the Lucas Critique. One of the industries in the spotlight during the period was the real estate industry. Values in the real estate market industry had been on an exponential increase in the period before 2008. Many residential areas were being put up by agents due to the demand-based models they had developed. This led to the real estate market flooding. During the time, agents to financial lenders approved loans to the residents of the US. The financial institutions developed a model that led to the selection of houses as mortgages for the people who wanted loans. However, no recent background studies were done on the people who were supposed to receive the loans. People who could not pay applied and got loans that most used to sustain their businesses. The implication of the financial sector also meant the financial industry was also involved. The finances that were being disbursed to the agents for loaning came from the government’s efforts of improving the economy through quantitative easing. Quantitative easing implies that the central government adopted the printing of new money to increase the supply of money into the economy. However, after the financial institutions loaned out the money, a problem arose among most of the borrowers. Most of the borrowers could neither service nor fully repay their loans. After a few years, the financial institutions seized the houses which were security on loans. Financial institutions had based their models on previous data which had shown increasing prices in the real estate industry. After seizing the houses, the financial institutions found themselves with large amounts of money to recoup from the sales of houses in a flooded market. Flooding of the real estate market implied that the prices of the houses had gone down. The houses had no buyer which hampered the efforts of the financial institutions in reacquiring the money. With the adoption of a Lucas critique when formulation these policies, the number of houses coming up and the abilities of people to pay loans questioned. Taking in all significant factors in the formulation of models results in more accurate and realistic models.