Testing Long Run Neutrality

K ey classical macroeconomic hypotheses specify that permanentchanges in nominal variables have no effect on real economic vari-ables in the long run. The simplest “long-run neutrality ” proposition specifies that a permanent change in the money stock has no long-run con-sequences for the level of real output. Other classical hypotheses specify that a permanent change in the rate of inflation has no long-run effect on unem-ployment (a vertical long-run Phillips curve) or real interest rates (the long-run Fisher relation). In this article we provide an econometric framework for study-ing these classical propositions and use the framework to investigate their relevance for the postwar U.S. experience. Testing these propositions is a subtle matter. For example, Lucas (1972) and Sargent (1971) provide examples in which it is impossible to test long-run neutrality using reduced-form econometric methods. Their examples feature rational expectations together with short-run nonneutrality and exogenous vari-ables that follow stationary processes so that the data generated by these models do not contain the sustained changes necessary to directly test long-run neu-trality. In the context of these models, Lucas and Sargent argued that it was