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 that the Federal Reserve is considering an increase in the federal funds rate target to fight inflation and promote a low inflation economic environment that promotes 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 to this model?

Policy Conduct: Rules or Discretion?