Question

) According to the Lucas critique, what is the proper way to evaluate a proposal that reduces government borrowing by raising taxes and reducing government spending

Answer 1

The Lucas critique emphasizes that changes in economic policy are likely to affect expectations of future policy and economic conditions, and such expectations have a strong impact on the behavioral response to the policy. Though aggregate income is reduced when taxes rise and government spending is reduced, people might expect that the reduction in government borrowing will lead to better economic conditions in the future. Proper policy evaluation must recognize that such optimism can counter the decrease in aggregate demand that might otherwise occur.