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

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  • André Kurmann

    (Université du Québec à Montréal, CIRPÉE)

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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Bibliographic Info

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

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

Note: Type of Document - pdf; pages: 37
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Web page: http://128.118.178.162

Related research

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

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References

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  1. Jondeau, E. & Le Bihan, H., 2001. "Testing for a Forward-Looking Phillips Curve. Additional Evidence from European and US Data," Working papers 86, Banque de France.
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  6. Jordi Galí & Mark Gertler, 1998. "Inflation dynamics: A structural econometric analysis," Economics Working Papers 341, Department of Economics and Business, Universitat Pompeu Fabra.
  7. Eric JONDEAU & Herve LE BIHAN, 2004. "ML vs GMM Estimates of Hybrid Macroeconomic Models (With an Application to the "New Phillips Curve")," Econometric Society 2004 North American Summer Meetings 270, Econometric Society.
  8. Jeff Fuhrer & George Moore, 1993. "Inflation persistence," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
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  24. Robrt G. King & André 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.
  25. Peter Tinsley & Sharon Kozicki, 2003. "Alternative Sources of the Lag Dynamics of Inflation," Computing in Economics and Finance 2003 92, Society for Computational Economics.
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Citations

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Cited by:
  1. Sheedy, Kevin D., 2010. "Intrinsic inflation persistence," Journal of Monetary Economics, Elsevier, vol. 57(8), pages 1049-1061, November.
  2. Luca Fanelli, 2008. "Testing the New Keynesian Phillips Curve Through Vector Autoregressive Models: Results from the Euro Area," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 70(1), pages 53-66, 02.
  3. Jordi Gali & Mark Gertler & David Lopez-Salido, 2005. "Robustness of the Estimates of the Hybrid New Keynesian Phillips Curve," NBER Working Papers 11788, National Bureau of Economic Research, Inc.
  4. Fanelli, Luca, 2007. "Evaluating the New Keynesian Phillips Curve under VAR-based learning," MPRA Paper 1616, University Library of Munich, Germany.
  5. Hasan Bakhshi & Hashmat Khan & Barbara Rudolf, 2004. "The Phillips curve under state-dependent pricing," Bank of England working papers 227, Bank of England.
  6. Fanelli, Luca, 2008. "Evaluating New Keynesian Phillips Curve under VAR-Based Learning," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy, vol. 2(33), pages 1-24.
  7. Linde, Jesper, 2005. "Estimating New-Keynesian Phillips curves: A full information maximum likelihood approach," Journal of Monetary Economics, Elsevier, vol. 52(6), pages 1135-1149, September.
  8. 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.
  9. André Kurmann, 2003. "Quantifying the Uncertainty about the Fit of a New Keynesian Pricing Model: Extended Version," Cahiers de recherche 0344, CIRPEE.
  10. Rudolf, B. & Bakhshi, H., 2005. "The Phillips Curve Under State-Dependent Pricing," Computing in Economics and Finance 2005 68, Society for Computational Economics.

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