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Counterfactual Analysis in Macroeconometrics: An Empirical Investigation into the Effects of Quantitative Easing

  • M. Hashem Pesaran

    (University of Southern California
    Trinity College Cambridge)

  • Ron P Smith

    (Department of Economics, Mathematics & Statistics, Birkbeck)

The policy innovations that followed the recent Great Recession, such as unconventional monetary policies, prompted renewed interest in the question of how to measure the effectiveness of such policy interventions. To test policy effectiveness requires a model to construct a counterfactual for the outcome variable in the absence of the policy intervention and a way to determine whether the differences between the realised outcome and the model-based counter-factual outcomes are larger than what could have occurred by chance in the absence of policy intervention. Pesaran & Smith propose tests of policy ineffectiveness in the context of macroeconometric rational expectations dynamic stochastic general equilibrium models. When we are certain of the specification, estimation of the complete system imposing all the cross-equation restrictions implied by the full structural model is more efficient. But if the full model is misspecified, one may obtain more reliable estimates of the counterfactual outcomes from a parsimonious reduced form policy response equation, which conditions on lagged values, and on the policy measures and variables known to be invariant to the policy intervention. We propose policy ineffectiveness tests based on such reduced forms and illustrate the tests with an application to the unconventional monetary policy known as quantitative easing (QE) adopted in the UK.

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Paper provided by Birkbeck, Department of Economics, Mathematics & Statistics in its series Birkbeck Working Papers in Economics and Finance with number 1406.

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Date of creation: Jun 2014
Handle: RePEc:bbk:bbkefp:1406
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