Question

Suppose an econometric model based on past data predicts a small decrease in domestic investment when the Federal Reserve increases the federal funds rate. Assume the Federal Reserve is considering an increase in the federal funds rate target to fight inflation and promote a low inflation environment that will encourage investment and economic growth.

a. Discuss the implications of the econometric model’s predictions if individuals interpret the increase in the federal funds rate target as a sign that the Fed will keep inflation at low levels in the long run.

b. What would be Lucas’s critique of this model?

Short answer

a. The consumer cost of capital rises while investment falls.

b. Lucas's critique will point out that the model was most likely built using historical data.

Step-by-step solution

Content Introduction

The Taylor Rule is a model for predicting interest rates. According to the Taylor Rule, the Federal Reserve should raise rates when inflation is over target or when GDP growth is excessively high and above potential. The consumer price index (CPI), producer prices, and the employment index all influence prices and inflation.

Explanation (Part a)

In the short and long run, an increase in the federal funds rate implies an increase in real interest rates. As a result, the consumer cost of capital rises while investment falls.

Explanation (Part b)

Lucas's critique will point out that the model was most likely built using historical data showing that domestic investment fell as interest rates rose, and that people's expectations can change quickly, causing them to modify how they react to interest rate changes.