The Lucas Critique and the Stability of Empirical Models

33 Pages Posted: 7 Dec 2012

See all articles by Thomas Lubik

Thomas Lubik

Federal Reserve Banks - Federal Reserve Bank of Richmond

Paolo Surico

London Business School - Department of Economics; Centre for Economic Policy Research (CEPR)

Date Written: July 1, 2006

Abstract

Empirical evidence suggests that movements in international relative prices (such as the real exchange rate) are large and persistent. Nontraded goods, both in the form of final consumption goods and as an input into the production of final tradable goods, are an important aspect behind international relative price movements. In this paper we show that nontraded goods have important implications for exchange rate behavior, even though fluctuations in the relative price of nontraded goods account for a relatively small fraction of real exchange rate movements. In our quantitative study nontraded goods magnify the volatility of exchange rates when compared to the model without nontraded goods. Cross-country correlations and the correlation of exchange rates with other macro variables are closer in line with the data. In addition, contrary to a large literature,standard alternative assumptions about the currency in which firms price their goods are virtually inconsequential for the properties of aggregate variables in our model, other than the terms of trade.

Keywords: Lucas critique, heteroskedasticity, parameter stability tests, rational expectations, indeterminacy

JEL Classification: C52, E38, E52

Suggested Citation

Lubik, Thomas and Surico, Paolo, The Lucas Critique and the Stability of Empirical Models (July 1, 2006). FRB Richmond Working Paper No. 06-05. Available at SSRN: https://ssrn.com/abstract=2186161 or http://dx.doi.org/10.2139/ssrn.2186161

Thomas Lubik (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

Paolo Surico

London Business School - Department of Economics ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

HOME PAGE: http://sites.google.com/site/paolosurico

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

HOME PAGE: http://sites.google.com/site/paolosurico

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