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We investigate the Bayesian approach to model comparison within a two-country framework with nominal rigidities using the workhorse New Keynesian open-economy model of…
We investigate the Bayesian approach to model comparison within a two-country framework with nominal rigidities using the workhorse New Keynesian open-economy model of Martínez-García and Wynne (2010). We discuss the trade-offs that monetary policy – characterized by a Taylor-type rule – faces in an interconnected world, with perfectly flexible exchange rates. We then use posterior model probabilities to evaluate the weight of evidence in support of such a model when estimated against more parsimonious specifications that either abstract from monetary frictions or assume autarky by means of controlled experiments that employ simulated data. We argue that Bayesian model comparison with posterior odds is sensitive to sample size and the choice of observable variables for estimation. We show that posterior model probabilities strongly penalize overfitting, which can lead us to favor a less parameterized model against the true data-generating process when the two become arbitrarily close to each other. We also illustrate that the spillovers from monetary policy across countries have an added confounding effect.
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)…
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.
This volume of Advances in Econometrics is devoted to dynamic stochastic general equilibrium (DSGE) models, which have gained popularity in both academic and policy circles as a theoretically and methodologically coherent way of analyzing a variety of issues in empirical macroeconomics. The volume is divided into two parts. The first part covers important topics in DSGE modeling and estimation practice, including the modeling and role of expectations, the study of alternative pricing models, the problem of non-invertibility in structural VARs, the possible weak identification in new open economy macro models, and the modeling of trend inflation. The second part is devoted to innovations in econometric methodology. The papers in this section advance new techniques for addressing key theoretical and inferential problems and include discussion and applications of Laplace-type, frequency domain, empirical likelihood, and method of moments estimators.
The chapter considers parameter identification, estimation, and model diagnostics in medium scale DSGE models from a frequency domain perspective using the framework…
The chapter considers parameter identification, estimation, and model diagnostics in medium scale DSGE models from a frequency domain perspective using the framework developed in Qu and Tkachenko (2012). The analysis uses Smets and Wouters (2007) as an illustrative example, motivated by the fact that it has become a workhorse model in the DSGE literature. For identification, in addition to checking parameter identifiability, we derive the non-identification curve to depict parameter values that yield observational equivalence, revealing which and how many parameters need to be fixed to achieve local identification. For estimation and inference, we contrast estimates obtained using the full spectrum with those using only the business cycle frequencies to find notably different parameter values and impulse response functions. A further comparison between the nonparametrically estimated and model implied spectra suggests that the business cycle based method delivers better estimates of the features that the model is intended to capture. Overall, the results suggest that the frequency domain based approach, in part due to its ability to handle subsets of frequencies, constitutes a flexible framework for studying medium scale DSGE models.
The role of trend inflation shocks for the U.S. macroeconomic dynamics is investigated by estimating two DSGE models of the business cycle. Policymakers are assumed to be…
The role of trend inflation shocks for the U.S. macroeconomic dynamics is investigated by estimating two DSGE models of the business cycle. Policymakers are assumed to be concerned with a time-varying inflation target, which is modeled as a persistent and stochastic process. The identification of trend inflation shocks (as opposed to a number of alternative innovations) is achieved by exploiting the measure of trend inflation recently proposed by Aruoba and Schorfheide (2011). Our main findings point to a substantial contribution of trend inflation shocks for the volatility of inflation and the policy rate. Such contribution is found to be time dependent and highest during the mid-1970s to mid-1980s.
Empirical work in macroeconomics almost universally relies on the hypothesis of rational expectations (RE).This chapter departs from the literature by considering a…
Empirical work in macroeconomics almost universally relies on the hypothesis of rational expectations (RE).
This chapter departs from the literature by considering a variety of alternative expectations formation models. We study the econometric properties of a popular New Keynesian monetary DSGE model under different expectational assumptions: the benchmark case of RE, RE extended to allow for “news” about future shocks, near-RE and learning, and observed subjective expectations from surveys.
The results show that the econometric evaluation of the model is extremely sensitive to how expectations are modeled. The posterior distributions for the structural parameters significantly shift when the assumption of RE is modified. Estimates of the structural disturbances under different expectation processes are often dissimilar.
The modeling of expectations has important effects on the ability of the model to fit macroeconomic time series. The model achieves its worse fit under RE. The introduction of news improves fit. The best-fitting specifications, however, are those that assume learning. Expectations also have large effects on forecasting. Survey expectations, news, and learning all work to improve the model's one-step-ahead forecasting accuracy. RE, however, dominate over longer horizons, such as one-year ahead or beyond.
This paper surveys the treatment of expectations in estimated Dynamic Stochastic General Equilibrium (DSGE) macroeconomic models.A recent notable development in the…
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.