Using Parameter Instability to Test Economic Theories

This paper develops new methods for testing structural hypotheses based on tests for parameter instability. It is shown that when the structure is of a particular type and its parameters change, predictable patterns of stability and instability in certain empirical relationships will result. These empirical characteristics are contingent on the type of structure involved. The paper develops different procedures for testing exogenous, recursive or long-run neutral structural relationships. And since the results are necessary and sufficient conditions, measurement could precede theory; Patterns of stable and unstable empirical relationships could be used to determine if these three types of structure are consistent with the evidence. JEL Codes: C12, C52, C32 * I thank seminar participants at 2005 Winter Econometric Society Meetings, Emory University, University of Georgia, University of Kansas and the Missouri Economics Conference for providing very helpful comments on a related paper