Maximum Likelihood Estimation of Dynamic Stochastic Theories with an Application to New Keynesian Pricing

37 Pages Posted: 30 Sep 2004

See all articles by André Kurmann

André Kurmann

Drexel University - LeBow College of Business

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Date Written: September 29, 2004

Abstract

This paper proposes a novel Maximum Likelihood (ML) strategy to estimate Euler equations implied by dynamic stochastic theories. The strategy exploits rational expectations cross-equation restrictions, but circumvents the problem of multiple solutions that arises in Sargent's (1979) original work by imposing the restrictions on the forcing variable rather than the endogenous variable of the Euler equation. The paper then contrasts the proposed strategy to an alternative, widely employed method that avoids the multiplicity problem by constraining the ML estimates to yield a unique stable solution. I argue that imposing such a uniqueness condition makes little economic sense and can lead to severe misspecification. To illustrate this point, I estimate Gali and Gertler's (1999) hybrid New Keynesian Phillips Curve using labor income share as the measure of real marginal cost. My ML estimates indicate that forward-looking behavior is predominant and that the model provides a good approximation of U.S. inflation dynamics. By contrast, if the same estimates are constrained to yield a unique stable solution, forward-looking behavior becomes much less important and the model as a whole is rejected.

Keywords: Maximum Likelihood, Rational Expectations, New Keynesian Phillips Curve, Inflation, Real marginal cost

JEL Classification: C13, E31, E32

Suggested Citation

Kurmann, André, Maximum Likelihood Estimation of Dynamic Stochastic Theories with an Application to New Keynesian Pricing (September 29, 2004). Available at SSRN: https://ssrn.com/abstract=597683 or http://dx.doi.org/10.2139/ssrn.597683

André Kurmann (Contact Author)

Drexel University - LeBow College of Business ( email )

School of Economics
3220 Market Street
Philadelphia, PA 19104
United States

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