The Misspecification of Expectations in New Keynesian Models: A DSGE-VAR Approach

40 Pages Posted: 9 Nov 2016

See all articles by Stephen J. Cole

Stephen J. Cole

Marquette University

Fabio Milani

University of California, Irvine - Department of Economics

Date Written: September 2016

Abstract

This paper tests the ability of popular New Keynesian models, which are traditionally used to study monetary policy and business cycles, to match the data regarding a key channel for monetary transmission: the dynamic interactions between macroeconomic variables and their corresponding expectations. In the empirical analysis, we exploit direct data on expectations from surveys. To explain the joint evolution of realized variables and expectations, we adopt a DSGE-VAR approach, which allows us to estimate all models in the continuum between the extremes of an unrestricted VAR, on one side, and a DSGE model in which the cross-equation restrictions are dogmatically imposed, on the other side. Moreover, the DSGE-VAR approach allows us to assess the extent, as well as the main sources, of misspecification in the model. The paper’s results illustrate the failure of New Keynesian models under the rational expectations hypothesis to account for the dynamic interactions between observed macroeconomic expectations and macroeconomic realizations. Confirming previous studies, DSGE restrictions prove valuable when the New Keynesian model is exempted from matching observed expectations. But when the model is required to match data on expectations, it can do so only by moving away, and hence substantially rejecting, DSGE restrictions. Finally, we investigate alternative models of expectations formation, including examples of extrapolative and heterogeneous expectations, and show that they can go some way toward reconciling the New Keynesian model with the data. Intermediate DSGE-VAR models, which avail themselves of DSGE prior restrictions, return to fit the data better than the unrestricted VAR. Hence, the results overall point to misspecification in the expectations formation side of the DSGE model, more than in the structural microfounded equations.

Keywords: modeling of expectations, DSGE models, rational expectations, observed survey expectations, model misspecification, DSGE-VAR, heterogeneous expectations

JEL Classification: C520, D840, E320, E500, E600

Suggested Citation

Cole, Stephen J. and Milani, Fabio, The Misspecification of Expectations in New Keynesian Models: A DSGE-VAR Approach (September 2016). CESifo Working Paper Series No. 6099, Available at SSRN: https://ssrn.com/abstract=2866863 or http://dx.doi.org/10.2139/ssrn.2866863

Stephen J. Cole

Marquette University ( email )

P.O. Box 1881
Milwaukee, WI 53201-1881
United States

Fabio Milani (Contact Author)

University of California, Irvine - Department of Economics ( email )

3151 Social Science Plaza
Irvine, CA 92697-5100
United States

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