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Equilibrium Counterfactuals

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  • Gilles Chemla
  • Christopher Hennessy

Abstract

We incorporate structural modelers into the economy they model. Using traditional moment matching, they treat policy changes as zero probability (or exogenous) “counterfactuals.” Bias occurs since real‐world agents understand policy changes are positive probability events guided by modelers. Downward, upward, or sign bias occurs. Bias is illustrated by calibrating the Leland model to the 2017 tax cut. The traditional identifying assumption, constant moment partial derivative sign, is incorrect with policy optimization. The correct assumption is constant moment total derivative sign accounting for estimation‐policy feedback. Model agent expectations can be updated iteratively until policy advice converges to agent expectations, with bias vanishing.

Suggested Citation

  • Gilles Chemla & Christopher Hennessy, 2021. "Equilibrium Counterfactuals," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 62(2), pages 639-669, May.
    • Handle: RePEc:wly:iecrev:v:62:y:2021:i:2:p:639-669
    DOI: 10.1111/iere.12513
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