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Expectation Formation and Monetary DSGE Models: Beyond the Rational Expectations Paradigm

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  • Fabio Milani

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

  • Ashish Rajbhandari

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

Abstract

Empirical work in macroeconomics almost universally relies on the hypothesis of rational expectations. This paper departs from the literature by considering a variety of alternative expectations formation models. We study the econometric properties of a popular New Keynesian monetary DSGE model under different expectational assumptions: the benchmark case of rational expectations, rational expectations extended to allow for `news' about future shocks, near-rational expectations and learning, and observed subjective expectations from surveys. The results show that the econometric evaluation of the model is extremely sensitive to how expectations are modeled. The posterior distributions for the structural parameters significantly shift when the assumption of rational expectations is modified. Estimates of the structural disturbances under different expectation processes are often dissimilar. The modeling of expectations has important effects on the ability of the model to fit macroeconomic time series. The model achieves its worse fit under rational expectations. The introduction of news improves fit. The best-fitting specifications, however, are those that assume learning. Expectations also have large effects on forecasting. Survey expectations, news, and learning all work to improve the model's one-step-ahead forecasting accuracy. Rational expectations, however, dominate over longer horizons, such as one-year ahead or beyond.

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Bibliographic Info

Paper provided by University of California-Irvine, Department of Economics in its series Working Papers with number 111212.

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Length: 31 pages
Date of creation: Jun 2012
Date of revision:
Handle: RePEc:irv:wpaper:111212

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Related research

Keywords: Expectation formation; Rational expectations; News shocks; Adaptive learning; Survey expectations; Econometric evaluation of DSGE models; Forecasting;

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References

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  1. Bruce Preston, 2003. "Learning about monetary policy rules when long-horizon expectations matter," Working Paper, Federal Reserve Bank of Atlanta 2003-18, Federal Reserve Bank of Atlanta.
  2. Paul Levine & Joseph Pearlman & George Perendia & Bo Yang, 2012. "Endogenous Persistence in an estimated DSGE Model Under Imperfect Information," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 122(565), pages 1287-1312, December.
  3. Katharine S. Neiss & Edward Nelson, 2001. "The real interest rate gap as an inflation indicator," Bank of England working papers, Bank of England 130, Bank of England.
  4. Christoffel, Kai & Warne, Anders & Coenen, Günter, 2010. "Forecasting with DSGE models," Working Paper Series, European Central Bank 1185, European Central Bank.
  5. Schmitt-Grohé, Stephanie & Uribe, Martín, 2009. "What’s News in Business Cycles," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7201, C.E.P.R. Discussion Papers.
  6. Sergey Slobodyan & Raf Wouters, 2009. "Learning in an Estimated Medium-Scale DSGE Model," CERGE-EI Working Papers, The Center for Economic Research and Graduate Education - Economic Institute, Prague wp396, The Center for Economic Research and Graduate Education - Economic Institute, Prague.
  7. Katharine Neiss & Edward Nelson, 2002. "Inflation dynamics, marginal cost, and the output gap: evidence from three countries," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Mar.
  8. Emi Nakamura & Jón Steinsson, 2008. "Five Facts about Prices: A Reevaluation of Menu Cost Models," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 123(4), pages 1415-1464, November.
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Citations

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Cited by:
  1. Fabio Milani, 2012. "The Modeling of Expectations in Empirical DSGE Models: a Survey," Working Papers, University of California-Irvine, Department of Economics 121301, University of California-Irvine, Department of Economics.
  2. Paul Beaudry & Franck Portier, 2013. "News Driven Business Cycles: Insights and Challenges," NBER Working Papers 19411, National Bureau of Economic Research, Inc.
  3. Fabio Milani & Ashish Rajrhandari, 2012. "Observed Expectations, News Shocks, and the Business Cycle," Working Papers, University of California-Irvine, Department of Economics 121305, University of California-Irvine, Department of Economics.

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