The Time-Varying-Parameter Model as an Alternative to Arch for Modeling Changing Conditional Variance: the Case of Lucas Hypothesis

34 Pages Posted: 27 Jun 2007 Last revised: 12 Sep 2010

See all articles by Charles R. Nelson

Charles R. Nelson

Dept of Economics

Chang-Jin Kim

Korea University; Dept. of Economics, University of Washington

Date Written: September 1988

Abstract

The main econometric issue in testing the Lucas hypothesis (1973) in a times series context is the estimation of the variance conditional on past information. The ARCH model, proposed by Engle (1982), is one way of specifying the conditional variance. But the assumption underlying the ARCH specification is ad-hoc. The existence of ARCH can sometimes be interpreted as evidence of misspecification. Under the assumption that a monetary policy regime is continuously changing, a time-varying-parameter (TVP) model is proposed for the monetary growth function. Based on Kalman filtering estimation of recursive forcast errors and their conditional variances, the Lucas hypothesis is tested for the U.S. economy (1964.1 - 1985.4) using monetary growth as an 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 forcast error term in the Lucas-type output equation.

Suggested Citation

Nelson, Charles R. and Kim, Chang-Jin, The Time-Varying-Parameter Model as an Alternative to Arch for Modeling Changing Conditional Variance: the Case of Lucas Hypothesis (September 1988). NBER Working Paper No. t0070, Available at SSRN: https://ssrn.com/abstract=994512

Charles R. Nelson (Contact Author)

Dept of Economics ( email )

Box 353330
Seattle, WA 98195-3330
United States

Chang-Jin Kim

Korea University ( email )

Anam-dong, Sungbuk-Ku
Dept. of Economics, Korea University
Seoul 136-701
Korea

HOME PAGE: http://econ.korea.ac.kr/~cjkim/

Dept. of Economics, University of Washington ( email )

Department of Economics (Box 353330)
University of Washington
Seattle, WA 98195-3330
United States

HOME PAGE: http://econ.korea.ac.kr/~cjkim/

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