Constructing Multi‐Country Rational Expectations Models

29 Pages Posted: 28 Oct 2014

See all articles by Stephane Dees

Stephane Dees

European Central Bank (ECB)

M. Hashem Pesaran

University of Southern California - Department of Economics; University of Cambridge - Trinity College (Cambridge)

L. Vanessa Smith

University of York - Department of Economics and Related Studies

Ron Smith

Birkbeck College

Date Written: December 2014

Abstract

This article considers some of the technical issues involved in using the global vector autoregression (GVAR) approach to construct a multi‐country rational expectations (RE) model and illustrates them with a new Keynesian model for 33 countries estimated with quarterly data over the period 1980–2011. The issues considered are: the measurement of steady states; the determination of exchange rates and the specification of the short‐run country‐specific models; the identification and estimation of the model subject to the theoretical constraints required for a determinate rational expectations solution; the solution of a large RE model; the structure and estimation of the covariance matrix and the simulation of shocks. The model used as an illustration shows that global demand and supply shocks are the most important drivers of output, inflation and interest rates in the long run. By contrast, monetary or exchange rate shocks have only a short‐run impact in the evolution of the world economy. The article also shows the importance of international connections, directly as well as indirectly through spillover effects. Overall, ignoring global inter‐connections as country‐specific models do, could give rise to misleading conclusions.

Suggested Citation

Dees, Stephane and Pesaran, M. Hashem and Smith, L. Vanessa and Smith, Ron P., Constructing Multi‐Country Rational Expectations Models (December 2014). Oxford Bulletin of Economics and Statistics, Vol. 76, Issue 6, pp. 812-840, 2014, Available at SSRN: https://ssrn.com/abstract=2515611 or http://dx.doi.org/10.1111/obes.12046

Stephane Dees (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

M. Hashem Pesaran

University of Southern California - Department of Economics

3620 South Vermont Ave. Kaprielian (KAP) Hall 300
Los Angeles, CA 90089
United States

University of Cambridge - Trinity College (Cambridge) ( email )

United Kingdom

L. Vanessa Smith

University of York - Department of Economics and Related Studies ( email )

Heslington
University of York
York, YO10 5DD
United Kingdom

Ron P. Smith

Birkbeck College ( email )

Malet Street
London WC1E 7HX
United Kingdom
+44 207 631 6413 (Phone)
+44 207 631 6416 (Fax)

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