THE UK CONSUMPTION FUNCTION AND STRUCTURAL INSTABILITY - IMPROVING FORECASTING PERFORMANCE USING A TIME-VARYING PARAMETER APPROACH

Previous studies indicate that the poor forecasting performance of con stant parameter UK consumption expenditure models is caused by structu ral instability in the underlying data generating process. Typically, this instability is removed by reparameterization within the constant parameter framework. An alternative modelling strategy is to allow som e, or all, of the parameters to vary over time. A UK non-durable consu mption expenditure model with time-varying parameters is developed, ba sed on the permanent income hypothesis of Friedman (1957). This model takes into account temporal changes in the average and marginal propen sities to consume. The variation in the parameter estimates is given a n economic interpretation in terms of the influence of omitted variabl es, namely UK financial liberalization and expectational changes. The forecasting performance of this model is superior to that of two widel y used constant parameter models. Further tests show that, even if the se constant parameter models are respecified as time varying parameter models, the authors' model still retains a superior forecasting perfo rmance.