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

Author

Listed:
  • Stephen J. Cole
  • Fabio Milani
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.

Suggested Citation

  • Stephen J. Cole & Fabio Milani, 2016. "The Misspecification of Expectations in New Keynesian Models: A DSGE-VAR Approach," CESifo Working Paper Series 6099, CESifo.
    • Handle: RePEc:ces:ceswps:_6099
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    1. Alan S. Blinder & Michael Ehrmann & Marcel Fratzscher & Jakob De Haan & David-Jan Jansen, 2008. "Central Bank Communication and Monetary Policy: A Survey of Theory and Evidence," Journal of Economic Literature, American Economic Association, vol. 46(4), pages 910-945, December.
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    Cited by:

    1. Patrick Fève & Jean‐Guillaume Sahuc, 2017. "In Search of the Transmission Mechanism of Fiscal Policy in the Euro Area," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 32(3), pages 704-718, April.
    2. Chatterjee, Pratiti & Milani, Fabio, 2020. "Perceived uncertainty shocks, excess optimism-pessimism, and learning in the business cycle," Journal of Economic Behavior & Organization, Elsevier, vol. 179(C), pages 342-360.
    3. Giovanni Angelini & Luca Fanelli, 2016. "Misspecification and Expectations Correction in New Keynesian DSGE Models," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 78(5), pages 623-649, October.
    4. Babecký, Jan & Franta, Michal & Ryšánek, Jakub, 2018. "Fiscal policy within the DSGE-VAR framework," Economic Modelling, Elsevier, vol. 75(C), pages 23-37.
    5. Roberta Cardani & Alessia Paccagnini & Stelios D. Bekiros, 2017. "The Effectiveness of Forward Guidance in an Estimated DSGE Model for the Euro Area: the Role of Expectations," Working Papers 201701, School of Economics, University College Dublin.
    6. Ilabaca, Francisco & Milani, Fabio, 2021. "Heterogeneous expectations, indeterminacy, and postwar US business cycles," Journal of Macroeconomics, Elsevier, vol. 68(C).
    7. Paola Mariell Brens Ortega, 2020. "An Econometric Analysis of a Calibrated Macroeconomic Model for the Dominican Republic: A Closer Look into Monetary Policy," Documentos de Trabajo 18253, The Latin American and Caribbean Economic Association (LACEA).
    8. Cole, Stephen J. & Martínez-García, Enrique, 2023. "The effect of central bank credibility on forward guidance in an estimated New Keynesian model," Macroeconomic Dynamics, Cambridge University Press, vol. 27(2), pages 532-570, March.
    9. Benchimol, Jonathan & Bounader, Lahcen, 2023. "Optimal monetary policy under bounded rationality," Journal of Financial Stability, Elsevier, vol. 67(C).
    10. Lance Kent, 2015. "Relaxing Rational Expectations," Working Papers 159, Department of Economics, College of William and Mary.
    11. Warne, Anders, 2023. "DSGE model forecasting: rational expectations vs. adaptive learning," Working Paper Series 2768, European Central Bank.
    12. Guimarães, Rodrigo, 2014. "Expectations, risk premia and information spanning in dynamic term structure model estimation," Bank of England working papers 489, Bank of England.
    13. Greta Meggiorini & Fabio Milani, 2021. "Behavioral New Keynesian Models: Learning vs. Cognitive Discounting," Working Papers 202103, University of California-Irvine, Department of Economics.
    14. Cole, Stephen J. & Milani, Fabio, 2021. "Heterogeneity in individual expectations, sentiment, and constant-gain learning," Journal of Economic Behavior & Organization, Elsevier, vol. 188(C), pages 627-650.
    15. Cole, Stephen J. & Huh, Sungjun, 2024. "Measuring the effects of unconventional monetary policy tools under adaptive learning," Journal of Economic Dynamics and Control, Elsevier, vol. 164(C).
    16. Milani, Fabio & Rajbhandari, Ashish, 2020. "Observed expectations, news shocks, and the business cycle," Research in Economics, Elsevier, vol. 74(2), pages 95-118.
    17. Jan Babecky & Michal Franta & Jakub Rysanek, 2016. "Effects of Fiscal Policy in the DSGE-VAR Framework: The Case of the Czech Republic," Working Papers 2016/09, Czech National Bank.
    18. Ina Hajdini, 2022. "Mis-specified Forecasts and Myopia in an Estimated New Keynesian Model," Working Papers 22-03R, Federal Reserve Bank of Cleveland, revised 06 Mar 2023.
    19. repec:spo:wpmain:info:hdl:2441/7t8isspkbs8hk8kol9kk9sjdl6 is not listed on IDEAS
    20. Cole, Stephen J., 2020. "The influence of learning and price-level targeting on central bank forward guidance," Journal of Macroeconomics, Elsevier, vol. 65(C).
    21. repec:hal:spmain:info:hdl:2441/7t8isspkbs8hk8kol9kk9sjdl6 is not listed on IDEAS
    22. Sorge, Marco M., 2021. "Stabilizing Taylor rules and determinacy under unit root supply shocks: A re-examination," Journal of Macroeconomics, Elsevier, vol. 68(C).
    23. Aguilar, Pablo & Vázquez, Jesús, 2021. "An Estimated Dsge Model With Learning Based On Term Structure Information," Macroeconomic Dynamics, Cambridge University Press, vol. 25(7), pages 1635-1665, October.
    24. Ciccarelli, Matteo & Darracq Pariès, Matthieu & Priftis, Romanos & Angelini, Elena & Bańbura, Marta & Bokan, Nikola & Fagan, Gabriel & Gumiel, José Emilio & Kornprobst, Antoine & Lalik, Magdalena & Mo, 2024. "ECB macroeconometric models for forecasting and policy analysis," Occasional Paper Series 344, European Central Bank.

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    More about this item

    Keywords

    modeling of expectations; DSGE models; rational expectations; observed survey expectations; model misspecification; DSGE-VAR; heterogeneous expectations;
    All these keywords.

    JEL classification:

    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • E60 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General

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