# Linear identification of linear rational-expectations models by exogenous variables reconciles Lucas and Sims

*Peter Zadrozny*

No 682, CFS Working Paper Series from Center for Financial Studies (CFS)

**Abstract:**
Linear rational-expectations models (LREMs) are conventionally "forwardly" estimated as follows. Structural coefficients are restricted by economic restrictions in terms of deep parameters. For given deep parameters, structural equations are solved for "rational-expectations solution" (RES) equations that determine endogenous variables. For given vector autoregressive (VAR) equations that determine exogenous variables, RES equations reduce to reduced-form VAR equations for endogenous variables with exogenous variables (VARX). The combined endogenous-VARX and exogenous-VAR equations comprise the reduced-form overall VAR (OVAR) equations of all variables in a LREM. The sequence of specified, solved, and combined equations defines a mapping from deep parameters to OVAR coefficients that is used to forwardly estimate a LREM in terms of deep parameters. Forwardly-estimated deep parameters determine forwardly-estimated RES equations that Lucas (1976) advocated for making policy predictions in his critique of policy predictions made with reduced-form equations. Sims (1980) called economic identifying restrictions on deep parameters of forwardly-estimated LREMs "incredible", because he considered in-sample fits of forwardly-estimated OVAR equations inadequate and out-of-sample policy predictions of forwardly-estimated RES equations inaccurate. Sims (1980, 1986) instead advocated directly estimating OVAR equations restricted by statistical shrinkage restrictions and directly using the directly-estimated OVAR equations to make policy predictions. However, if assumed or predicted out-of-sample policy variables in directly-made policy predictions differ significantly from in-sample values, then, the out-of-sample policy predictions won't satisfy Lucas's critique. If directly-estimated OVAR equations are reduced-form equations of underlying RES and LREM-structural equations, then, identification 2 derived in the paper can linearly "inversely" estimate the underlying RES equations from the directly-estimated OVAR equations and the inversely-estimated RES equations can be used to make policy predictions that satisfy Lucas's critique. If Sims considered directly-estimated OVAR equations to fit in-sample data adequately (credibly) and their inversely-estimated RES equations to make accurate (credible) out-of-sample policy predictions, then, he should consider the inversely-estimated RES equations to be credible. Thus, inversely-estimated RES equations by identification 2 can reconcile Lucas's advocacy for making policy predictions with RES equations and Sims's advocacy for directly estimating OVAR equations. The paper also derives identification 1 of structural coefficients from RES coefficients that contributes mainly by showing that directly estimated reduced-form OVAR equations can have underlying LREM-structural equations.

**Keywords:** cross-equation restrictions of rational expectations; factorization of matrix polynomials; reconciliation of Lucas's advocacy of rational-expectations modelling and policy predictions and Sims's advocacy of VAR modelling (search for similar items in EconPapers)

**JEL-codes:** C32 C43 C53 C63 (search for similar items in EconPapers)

**Date:** 2022

**New Economics Papers:** this item is included in nep-ecm

**References:** View references in EconPapers View complete reference list from CitEc

**Citations:** View citations in EconPapers (1)

**Downloads:** (external link)

https://www.econstor.eu/bitstream/10419/267684/1/1827196440.pdf (application/pdf)

**Related works:**

Working Paper: Linear Identification of Linear Rational-Expectations Models by Exogenous Variables Reconciles Lucas and Sims (2022)

This item may be available elsewhere in EconPapers: Search for items with the same title.

**Export reference:** BibTeX
RIS (EndNote, ProCite, RefMan)
HTML/Text

**Persistent link:** https://EconPapers.repec.org/RePEc:zbw:cfswop:682

Access Statistics for this paper

More papers in CFS Working Paper Series from Center for Financial Studies (CFS) Contact information at EDIRC.

Bibliographic data for series maintained by ZBW - Leibniz Information Centre for Economics ().