Monetary Policy Indeterminacy and Identification Failures in the U.S.: Results from a Robust Test

60 Pages Posted: 9 Aug 2014

See all articles by Efrem Castelnuovo

Efrem Castelnuovo

University of Melbourne - Department of Economics

Luca Fanelli

Universita di Bologna

Date Written: July 1, 2014

Abstract

We propose a novel identification-robust test for the null hypothesis that an estimated new-Keynesian model has a reduced form consistent with the unique stable solution against the alternative of sunspot-driven multiple equilibria. Our strategy is designed to handle identification failures as well as the misspecification of the relevant propagation mechanisms. We invert a likelihood ratio test for the cross-equation restrictions (CER) that the new-Keynesian system places on its reduced form solution under determinacy. If the CER are not rejected, sunspot-driven expectations can be ruled out from the model equilibrium and we accept the structural model. Otherwise, we move to a second-step and invert an Anderson and Rubin-type test for the orthogonality restrictions (OR) implied by the system of Euler equations. The hypothesis of indeterminacy and the structural model are accepted if the OR are not rejected. We investigate the finite sample performance of the suggested identification-robust two-steps testing strategy by some Monte Carlo experiments and then apply it to a new-Keynesian AD/AS model estimated with actual U.S. data. In spite of some evidence of weak identification as for the ‘Great Moderation’ period, our results offer formal support to the hypothesis of a switch from indeterminacy to a scenario consistent with uniqueness which occurred in the late 1970s. Our identification-robust full-information confidence set for the structural parameters computed on the ‘Great Moderation’ regime turns out to be more precise than the intervals previously reported in the literature through ‘limited-information’ methods.

Keywords: Confidence set, determinacy, identification failures, indeterminacy, misspecification, new-Keynesian business cycle model, VAR system

JEL Classification: C31, C22, E31, E52

Suggested Citation

Castelnuovo, Efrem and Fanelli, Luca, Monetary Policy Indeterminacy and Identification Failures in the U.S.: Results from a Robust Test (July 1, 2014). Melbourne Institute Working Paper No. 18/14. Available at SSRN: https://ssrn.com/abstract=2477654 or http://dx.doi.org/10.2139/ssrn.2477654

Efrem Castelnuovo (Contact Author)

University of Melbourne - Department of Economics ( email )

Melbourne, 3010
Australia

HOME PAGE: http://https://sites.google.com/site/efremcastelnuovo/home

Luca Fanelli

Universita di Bologna ( email )

Bologna, 40126
Italy

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