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

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Author Info
André Kurmann (Université du Québec à Montréal, CIRPÉE)

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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.

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Paper provided by EconWPA in its series Macroeconomics with number 0409028.

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Length: 37 pages
Date of creation: 29 Sep 2004
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Handle: RePEc:wpa:wuwpma:0409028

Note: Type of Document - pdf; pages: 37
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Related research
Keywords: Maximum Likelihood Rational Expectations New Keynesian Phillips Curve Inflation Real marginal cost.

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Find related papers by JEL classification:
C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Estimation
E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Mark Bils and Peter J. Klenow, 2004. "Some Evidence on the Importance of Sticky Prices," Journal of Political Economy, University of Chicago Press, vol. 112(5), pages 947-985, October.
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  2. Bils, Mark, 1987. "The Cyclical Behavior of Marginal Cost and Price," American Economic Review, American Economic Association, vol. 77(5), pages 838-55, December. [Downloadable!] (restricted)
  3. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December. [Downloadable!] (restricted)
    Other versions:
  4. James H. Stock & Motohiro Yogo, 2002. "Testing for Weak Instruments in Linear IV Regression," NBER Technical Working Papers 0284, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  5. Eric JONDEAU & Hervé LE BIHAN, 2003. "ML vs GMM Estimates of Hybrid Macroeconomic Models (With an Application to the "New Phillips Curve")," Econometrics 0303004, EconWPA. [Downloadable!]
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  6. Robrt G. King & Andre Kurmann, 2002. "Expectations and the term structure of interest rates : evidence and implications," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 49-95. [Downloadable!]
  7. King, Robert G & Watson, Mark W, 1998. "The Solution of Singular Linear Difference Systems under Rational Expectations," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 1015-26, November.
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  9. Sbordone, Argia M., 2005. "Do expected future marginal costs drive inflation dynamics?," Journal of Monetary Economics, Elsevier, vol. 52(6), pages 1183-1197, September. [Downloadable!] (restricted)
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  10. James M. Nason & Gregor W. Smith, 2005. "Identifying the New Keynesian Phillips Curve," Working Paper 2005-01, Federal Reserve Bank of Atlanta. [Downloadable!]
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  11. Hansen, Lars Peter & Sargent, Thomas J., 1980. "Formulating and estimating dynamic linear rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 2(2), pages 7-46, May. [Downloadable!] (restricted)
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  12. Sargent, Thomas J., 1979. "A note on maximum likelihood estimation of the rational expectations model of the term structure," Journal of Monetary Economics, Elsevier, vol. 5(1), pages 133-143, January. [Downloadable!] (restricted)
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  13. Gali, Jordi & Gertler, Mark, 1999. "Inflation dynamics: A structural econometric analysis," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 195-222, October. [Downloadable!] (restricted)
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  14. Eric Jondeau & Hervé Le Bihan, 2001. "Testing for a Forward-Looking Phillips Curve. Additional Evidence from European and US data," Macroeconomics 0111005, EconWPA. [Downloadable!]
  15. John M. Roberts, 2001. "How well does the New Keynesian sticky-price model fit the data?," Finance and Economics Discussion Series 2001-13, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  16. Frank Smets & Raf Wouters, 2003. "An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area," Journal of the European Economic Association, MIT Press, vol. 1(5), pages 1123-1175, 09. [Downloadable!] (restricted)
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  17. Stock, James H & Wright, Jonathan H & Yogo, Motohiro, 2002. "A Survey of Weak Instruments and Weak Identification in Generalized Method of Moments," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(4), pages 518-29, October.
  18. Alexander L. Wolman, 2000. "The frequency and costs of individual price adjustments," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 1-22. [Downloadable!]
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  19. Fuhrer, Jeff & Moore, George, 1995. "Inflation Persistence," The Quarterly Journal of Economics, MIT Press, vol. 110(1), pages 127-59, February. [Downloadable!] (restricted)
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  20. Fuhrer, Jeffrey C. & Rudebusch, Glenn D., 2004. "Estimating the Euler equation for output," Journal of Monetary Economics, Elsevier, vol. 51(6), pages 1133-1153, September. [Downloadable!] (restricted)
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  21. Sharon Kozicki & P.A. Tinsley, 2002. "Alternative sources of the lag dynamics of inflation," Research Working Paper RWP 02-12, Federal Reserve Bank of Kansas City. [Downloadable!]
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  22. Roberts, John M., 1997. "Is inflation sticky?," Journal of Monetary Economics, Elsevier, vol. 39(2), pages 173-196, July. [Downloadable!] (restricted)
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  23. Lubik, Thomas A. & Schorfheide, Frank, 2003. "Computing sunspot equilibria in linear rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 28(2), pages 273-285, November. [Downloadable!] (restricted)
  24. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September. [Downloadable!] (restricted)
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  26. Ma, Adrian, 2002. "GMM estimation of the new Phillips curve," Economics Letters, Elsevier, vol. 76(3), pages 411-417, August. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Rudolf, B. & Bakhshi, H., 2005. "The Phillips Curve Under State-Dependent Pricing," Computing in Economics and Finance 2005 68, Society for Computational Economics. [Downloadable!]
  2. Jordi Galí & Mark Gertler & David López-Salido, 2005. "Robustness of the Estimates of the Hybrid New Keynesian Phillips Curve," Banco de España Working Papers 0520, Banco de España. [Downloadable!]
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  3. Hasan Bakhshi & Hashmat Khan & Barbara Rudolf, . "The Phillips curve under state-dependent pricing," Bank of England working papers 227, Bank of England. [Downloadable!]
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  4. Fanelli, Luca, 2007. "Evaluating the New Keynesian Phillips Curve under VAR-based learning," MPRA Paper 1616, University Library of Munich, Germany. [Downloadable!]
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  5. André Kurmann, 2003. "Quantifying the Uncertainty about the Fit of a New Keynesian Pricing Model: Extended Version," Cahiers de recherche 0344, CIRPEE. [Downloadable!]
  6. Fanelli, Luca, 2005. "Testing the New Keynesian Phillips curve through Vector Autoregressive models: Results from the Euro area," MPRA Paper 1617, University Library of Munich, Germany, revised Jan 2007. [Downloadable!]
    Other versions:
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