The Misspecification of Expectations in New Keynesian Models: A DSGE-VAR Approach
Stephen Cole () and
Fabio Milani ()
No 131407, Working Papers from University of California-Irvine, Department of Economics
This paper tests the ability of popular New Keynesian models, which are traditionally used to study monetary policy and business cycles, to match the data regarding a key channel for monetary transmission: the dynamic interactions between macroeconomic variables and their corresponding expectations. In the empirical analysis, we exploit direct data on expectations from surveys. To explain the joint evolution of realized variables and expectations, we adopt a DSGE-VAR approach, which allows us to estimate all models in the continuum between the extremes of an unrestricted VAR, on one side, and a DSGE model in which the cross-equation restrictions are dogmatically imposed, on the other side. Moreover, the DSGE-VAR approach allows us to assess the extent, as well as the main sources, of misspecification in the model. The paper's results illustrate the failure of New Keynesian models under the rational expectations hypothesis to account for the dynamic interactions between observed macroeconomic expectations and macroeconomic realizations. Confirming previous studies, DSGE restrictions prove valuable when the New Keynesian model is exempted from matching observed expectations. But when the model is required to match data on expectations, it can do so only by moving away, and hence substantially rejecting, DSGE restrictions. Finally, we investigate alternative models of expectations formation, including examples of extrapolative and heterogeneous expectations, and show that they can go some way toward reconciling the New Keynesian model with the data. Intermediate DSGE-VAR models, which avail themselves of DSGE prior restrictions, return to fit the data better than the unrestricted VAR. Hence, the results overall point to misspecification in the expectations formation side of the DSGE model, more than in the structural microfounded equations.
Keywords: Modeling of expectations; DSGE models; Rational expectations; Observed survey expectations; Model misspecification; DSGE-VAR; Heterogeneous expectations (search for similar items in EconPapers)
JEL-codes: C52 D84 E32 E50 E60 (search for similar items in EconPapers)
Pages: 26 pages
New Economics Papers: this item is included in nep-dge, nep-ecm and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8) Track citations by RSS feed
Downloads: (external link)
Journal Article: THE MISSPECIFICATION OF EXPECTATIONS IN NEW KEYNESIAN MODELS: A DSGE-VAR APPROACH (2019)
This item may be available elsewhere in EconPapers: Search for items with the same title.
Export reference: BibTeX
RIS (EndNote, ProCite, RefMan)
Persistent link: https://EconPapers.repec.org/RePEc:irv:wpaper:131407
Access Statistics for this paper
More papers in Working Papers from University of California-Irvine, Department of Economics Contact information at EDIRC.
Bibliographic data for series maintained by Jennifer dos Santos ().