The Lucas Critique, DSGE models and the Phillips Curve

The Lucas Critique in 1976 has been a major motivation behind the building of RBC models, the folow-up DSGE models as well as the structural estimation of these models. The idea was that estimating reduced-form elasticities was not immune to policy variations, and those elasticities were being estimated to determine the impact of policy in the first place. The resulting bias reduced the trust in the Philipps curve. The structural models, however, had and still have at their core supposedly invariant parameters that describe some fundamentals of the economy. But it turns out that some of those are not invariant over time. I recently discussed the case of the labor income share (here). And misspecification can be problematic in the estimation of such structural models, with possibly important consequences.

Samuel Hurtado tries to sort that out by including parameter shifts in the estimation of a standard DSGE model, but misspecifying it in such a way that it ignores this shift. Using data form the 1970s, he then shows that the policy responses from his model look surprisingly close to those of a reduced-form Philipps curve. In other words, it seems the DSGE model without parameter shift is just as misspecified as the old Philipps curve. What this means is that one has to either include ad hoc parameter shifts or that one needs to go even deeper in the fundamentals to understand why and how these parameters shifts are occurring. The latter gives an even stronger meaning to the Lucas Critique.