Lucas Critique and the Stability of Demand for Money in Iran

Lucas has shown when agents use all available information optimally to form their expectations, the estimated coefficients might not be stable due to changes in policies. As a result, it is important to test the stability of paramters prior to use of any model for policy making and forecasting. Using the exogeneity tests in the context of Autoregressive Distributed Lags (ARDL) models, this paper studies the stability of demand for money in Iran for the period 1961-1998. This approach also enables us to estimate both short-run and the long-run relations among variables. In this reseach the narrow and the borad definitions of money - namely M1 and M2, respectively - are employed. The estimation results show that the income elasticity is positive and the price eslasticily of demand for money is negative. The results also show that there is an inverse relation between black market exchange rate and demand for real balances. This indicates "currency substitution" effect in the Iranian economy. The exogeneity tests illustrate that the gross domestic product (GDP), black market exchange rates and inflation rate are weakly exogenous. The results also indicate that the- super-exogencity is a valid assumption for GDP and inflation rate variables in the demand for M1 and M2. However, the model fails to confirm super exogeniety of black market exchange rates in the demand for M2.In other words, Lucas critique can not be rejected in this case. Hence, monetary authorities in Iran should take this fact into consideration when they include black market exchange rate in the demand for money.