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The Time-Varying-Parameter Model for Modeling Changing Conditional Variance: The Case of the Lucas Hypothesis

  • Kim, Chang-Jin
  • Nelson, Charles R

The main econometric issue in testing the Lucas (1973) hypothesis in a time series context is estimation of the forecast-error variance conditional on past information. The conditional variance may vary through time as monetary policy evolves and agents are obliged to infer its present state. Under the assumption that a monetary policy regime is continuously changing, a time-varying-parameter model is proposed for the monetary-growth function. Based on Kalman-filtering estimation of recursive forecast errors and their conditional variances, the Lucas hypothesis is tested for the U.S. economy (1964:1-1985:4) using monetary growth as aggregate demand variable. The Lucas hypothesis is rejected in favor of Friedman's (1977) hypothesis--the conditional variance of monetary growth affects real output directly, not through the coefficients on the forecast-error term in the Lucas-type output equation.

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Article provided by American Statistical Association in its journal Journal of Business and Economic Statistics.

Volume (Year): 7 (1989)
Issue (Month): 4 (October)
Pages: 433-40

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Handle: RePEc:bes:jnlbes:v:7:y:1989:i:4:p:433-40
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