ROBUST DECISION THEORY AND THE LUCAS CRITIQUE

Abstract

In this paper, we reconsider the theoretical basis for the Lucas critique from the point of view of robust decision theory. We first emphasize that the Lucas critique rests on a weak theoretical paradigm in that it fails to consider the motivation for the policy change by the government and hence inconsistently assumes limited rationality by the government. When placed in a proper dynamic general equilibrium framework of a dynamic game between the government and the private sector, much of the force of the critique simply vanishes. We also reconsider the critique by adopting an alternative theoretical paradigm and notion of rationality based on robust decision theory. This view of rationality might be regarded as more relevant than the nonrobust rationality employed by Lucas and, critically, it is one in which the Lucas critique can be shown simply not to apply, provided the private sector has adopted suitably robust decision rules.