Suppose an econometric model based on past data predicts a small decrease in domestic investment when the Bank of Canada increases the overnight interest rate. Assume that the Bank is considering an increase in the overnight rate target to fight inflation and promote a low inflation environment that promotes investment and economic growth.

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

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