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We test the determinacy properties of the standard and financial-sector-augmented Taylor rules in a new Keynesian model with a presence of banking activities. We extend the basic fully rational environment to the setting with heterogeneous expectations. We observe that the benefits from extra financial targeting are limited. Financial targeting, if well designed, can compensate for the improper output-gap targeting through the financial-production channel. The analysis demonstrates however possible threats resulting from the misspecification of the augmented rule. A determinate mix of output-gap and inflation weights can turn indeterminate if compensated by too extreme financial targeting. The results are robust to the presence of heterogeneous expectations.

Should the central bank target asset price inflation? In their 1999 paper Bernanke and Gertler claimed that price stability and financial stability are “mutually consistent objectives” in a flexible inflation targeting regime which “dictates that central banks … should not respond to changes in asset prices.” This conclusion is straightforward within their framework in which asset price inflation shows up as a factor “augmenting” the IS curve. In this chapter, we pursue a different modeling strategy so that, in the end, asset price dynamics will be incorporated into the NK Phillips curve. We put ourselves, therefore, in the best position to obtain a significant stabilizing role for asset price targeting. It turns out, however, that inflation volatility is higher in the asset price targeting case. After all, therefore, targeting asset prices may not be a good idea.

This paper surveys the treatment of expectations in estimated Dynamic Stochastic General Equilibrium (DSGE) macroeconomic models.

A recent notable development in the empirical macroeconomics literature has been the rapid growth of papers that build structural models, which include a number of frictions and shocks, and which are confronted with the data using sophisticated full-information econometric approaches, often using Bayesian methods.

A widespread assumption in these estimated models, as in most of the macroeconomic literature in general, is that economic agents' expectations are formed according to the Rational Expectations Hypothesis (REH). Various alternative ways to model the formation of expectations have, however, emerged: some are simple refinements that maintain the REH, but change the information structure along different dimensions, while others imply more significant departures from rational expectations.

I review here the modeling of the expectation formation process and discuss related econometric issues in current structural macroeconomic models. The discussion includes benchmark models assuming rational expectations, extensions based on allowing for sunspots, news, sticky information, as well as models that abandon the REH to use learning, heuristics, or subjective expectations.

Open-Economy models are central to the discussion of the trade-offs monetary policy faces in an increasingly more globalized world (e.g., Marínez-García & Wynne, 2010), but bringing them to the data is not without its challenges. Controlling for misspecification bias, we trace the problem of uncertainty surrounding structural parameter estimation in the context of a fully specified New Open Economy Macro (NOEM) model partly to sample size. We suggest that standard macroeconomic time series with a coverage of less than forty years may not be informative enough for some parameters of interest to be recovered with precision. We also illustrate how uncertainty also arises from weak structural identification, irrespective of the sample size. This remains a concern for empirical research and we recommend estimation with simulated observations before using actual data as a way of detecting structural parameters that are prone to weak identification. We also recommend careful evaluation and documentation of the implementation strategy (specially in the selection of observables) as it can have significant effects on the strength of identification of key model parameters.

It would be difficult to deny the claim that contemporary economics is one of very few disciplines to be defined less by its subject matter (the “economy”) than by its method—the maximization of some objective function by rational agents choosing among limitless means while being subject to particular constraints. In this formulation of our discipline, the autonomous maximizing agent is seen as the fundamental unit of analysis. In essence, contemporary economics reifies in its approach and its methods the modernist triumph of the sanctity of the individual over any other plausible social entity. Methodological individualism is more than a short-hand term for our methods. It is a term for our view of the world as it is and as it ought to be if aggregate well being (welfare) is to be maximized.

The Austrian economist Ludwig Lachmann claimed that Keynes was a lifelong subjectivist. To evaluate this, we start by distinguishing Keynes’ writings on probability theory from his writings on economics. In the General Theory (1936), Keynes’ treatment of expectations provides the basis for Lachmann’s view that Keynes was a subjectivist at heart. In his Treatise on Probability (1921), Keynes refers explicitly to the subjectivism–objectivism divide in probability theory and pins his colors to the objectivist mast. In this essay, we present the objectivist slant in Keynes’ earlier writings on probability theory. Thereafter, we evaluate the criteria Lachmann employed to cast Keynes as a subjectivist.