The Time-Varying-Parameter Model as an Alternative to ARCH for Modeling Changing Conditional Variance: The Case of Lucas Hypothesis / Charles R. Nelson, Chang-Jin Kim.

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Nelson, Charles R

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TextSeries: Technical Working Paper Series (National Bureau of Economic Research) ; no. t0070.Publication details: Cambridge, Mass. National Bureau of Economic Research 1988.Description: 1 online resource: illustrations (black and white)Online resources:

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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.

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Previous	nber t0067 The Dividend Ratio Model and Small Sample Bias: A Monte Carlo Study /	nber t0068 Some Further Results on the Exact Small Sample Properties of the Instrumental Variable Estimator /	nber t0069 The Distribution of the Instrumental Variables Estimator and Its t-RatioWhen the Instrument is a Poor One /	nber t0070 The Time-Varying-Parameter Model as an Alternative to ARCH for Modeling Changing Conditional Variance: The Case of Lucas Hypothesis /	nber t0071 Smart Money, Noise Trading and Stock Price Behavior /	nber t0072 The R&D Master File Documentation /	nber t0073 Tests For Unit Roots: A Monte Carlo Investigation /	Next

September 1988.

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.