Expectations and regime robustness in price formation: evidence from vector autoregressive models and recursive methods

Abstract

The forward-looking linear quadratic adjustment cost (LQAC) model has received attention when modelling prices. Empirical evidence supporting the model seems, however, ambiguous. We find that the LQAC-model is severely at odds with price data for Norwegian machinery exports also when the pure forward-looking rule is augmented by additional lags of the targeted variable. A conditional equilibrium correction (EqCM) model explains the export price behaviour more accurately. Our findings may rule out a large class of expectations based models and not just the particular LQAC-model in the formation of export prices. We also demonstrate that the EqCM-model performs well post-sample despite that monetary policy in Norway has changed from a fixed to a floating exchange rate regime following a recent introduction of inflation targeting. This regime robustness shows that the Lucas critique lacks force empirically in our case.