Equilibrium Counterfactuals

Posted: 23 Jul 2019 Last revised: 17 Nov 2019

See all articles by Gilles Chemla

Gilles Chemla

Imperial College Business School; CNRS ; Centre for Economic Policy Research (CEPR)

Christopher Hennessy

London Business School

Multiple version iconThere are 2 versions of this paper

Date Written: November 14, 2019

Abstract

We incorporate structural modellers into the economy they model. Using the traditional moment-matching method, they ignore policy feedback and estimate parameters using a structural model that treats policy changes as zero probability (or exogenous) "counterfactuals." Estimation bias occurs since the economy's actual agents, in contrast to model agents, understand policy changes are positive probability endogenous events guided by the modellers. We characterize equilibrium bias. Depending on technologies, downward, upward, or sign bias occurs. Potential bias magnitudes are illustrated by calibrating the Leland (1994) model to the Tax Cuts and Jobs Act of 2017. Regarding parameter identification, we show the traditional structural identifying assumption, constant moment partial derivative sign, is incorrect for economies with endogenous policy optimization: The correct identifying assumption is constant moment total derivative sign accounting for estimation-policy feedback. Under this assumption, model agent expectations can be updated iteratively until the modellers' policy advice converges to agent expectations, with bias vanishing.

Keywords: counterfactuals, structural models, moments, policy, bias, algorithm

JEL Classification: D0, G0, H0, G32

Suggested Citation

Chemla, Gilles and Hennessy, Christopher, Equilibrium Counterfactuals (November 14, 2019). Available at SSRN: https://ssrn.com/abstract=3424130 or http://dx.doi.org/10.2139/ssrn.3424130

Gilles Chemla (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom
+44 207 594 9161 (Phone)
+44 207 594 9210 (Fax)

CNRS ( email )

Dauphine Recherches en Management
Place du Marechal de Lattre de Tassigny
Paris, 75016
France
331 44054970 (Phone)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Christopher Hennessy

London Business School

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

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