THREE ESSAYS ON THE LUCAS SUPPLY FUNCTION, PARTIAL ADJUSTMENT OF INVENTORIES, AND TESTING OF THE PERMANENT INCOME HYPOTHESIS (VARIABLE SPEED, CONSUMPTION TIME SERIES, COSTS, INVENTORY HOLDING COSTS)

STEVEN SHEI-PING KAN, Purdue University

Abstract

Essay One provides a detailed critique of several recent derivations of a Lucas-type supply function, in which output responds to price surprises, and of the debate about whether it is nonstructural, i.e., whether policy parameters enter the supply function. The essay shows that the construct of a "normal employment level" is inessential in obtaining a nonstructural function. A nonstructural Lucas supply arises simply from the inability of the informational structure to reveal adequately the underlying shocks. Finally, the importance of intertemporal versus contemporaneous relative price confusion is overblown in relation to the issue of whether or not monetary policy is effective. The partial adjustment model as applied to inventory behaviors has long been plagued by implausibly low estimates of the adjustment speed and by a positive interest rate effect on the target stocks. Essay Two shows, in the framework of an optimal-control model, that the planned adjustment speed will vary with the interest rate. The adjustment speed will be slower as the interest rate increases if the inventory holding costs are constant. The variable-speed model is supported empirically by regression estimates with data from the durable manufacturing sector, and the interest rate does have a negative effect on the adjustment speed. An otherwise puzzling positive interest rate effect on target stocks is hence reconciled by incorporating a variable adjustment speed. Authors of recent tests of the joint hypotheses of permanent income and rational expectations have generally called for a rejection of the permanent income hypothesis (PIH). Essay Three considers a model of durable goods consumption with adjustment costs appearing in the budget constraint. When the interest rate follows a random walk and is independently distributed from other variables, the adjustment speed in durable goods consumption will increase as the interest rate increases if the interest-rate-induced permanent income effect dominates the substitution effect. In addition, both lagged interest rates and lagged income innovations can have effects on the consumption expenditures if the variable-speed is not incorporated in a regression. While these effects were the basis for others' rejection of the PIH, the essay shows that they are still consistent with the PIH. The essay concludes by discussing a proper test of the PIH in the short-run.

Degree

Ph.D.

Subject Area

Economics

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