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Model selection for monetary policy analysis How important is empirical validity?

  • Akram, Q. Farooq

    (Research Department, Norges Bank)

  • Nymoen, Ragnar

    ()

    (Dept. of Economics, University of Oslo)

We investigate the economic significance of trading off empirical validity of models against other desirable model properties, and the potential loss from ’overestimating’ model uncertainty and basing monetary policy on a relatively robust model, or on a suite of models. We find that differences in model specification and even differences in estimates of key parameters across comparable models may entail widely different monetary policy and macroeconomic performance. Our results therefore caution against compromising the empirical validity of models when selecting a model for policy analysis. We also find that potential costs from basing monetary policies on the relatively robust model or on a suite of models, even when it contains the valid model by assumption, can be quite substantial. This suggests huge gains from efficient exploitation of available information sources to avoid overestimation of model uncertainty. Our investigation is based on three alternative econometric systems of wage and price inflation for Norway

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File URL: http://www.sv.uio.no/econ/english/research/unpublished-works/working-papers/pdf-files/2007/Memo-14-2007.pdf
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Paper provided by Oslo University, Department of Economics in its series Memorandum with number 14/2007.

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Length: 38 pages
Date of creation: 09 Jul 2007
Date of revision:
Handle: RePEc:hhs:osloec:2007_014
Contact details of provider: Postal: Department of Economics, University of Oslo, P.O Box 1095 Blindern, N-0317 Oslo, Norway
Phone: 22 85 51 27
Fax: 22 85 50 35
Web page: http://www.oekonomi.uio.no/indexe.html
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  1. Q. Farook Akram & Gunnar Bårdsen & Øyvind Eitrheim, 2005. "Monetary policy and asset prices: To respond or not?," Working Paper 2005/9, Norges Bank.
  2. James H. Stock & Mark W. Watson, 1999. "Forecasting Inflation," NBER Working Papers 7023, National Bureau of Economic Research, Inc.
  3. Johansen, Kare, 1995. "Norwegian Wage Curves," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 57(2), pages 229-47, May.
  4. Gunnar Bårdsen & Eilev S. Jansen & Ragnar Nymoen, 1999. "Econometric Inflation Targeting," Working Paper Series 0502, Department of Economics, Norwegian University of Science and Technology, revised 30 Oct 2001.
  5. Batini, Nicoletta & Nelson, Edward, 2000. "Optimal Horizons for Inflation Targeting," Working Paper Series 103, Sveriges Riksbank (Central Bank of Sweden).
  6. Gordon, Robert J, 1996. "The Time-varying NAIRU and its Implications for Economic Policy," CEPR Discussion Papers 1492, C.E.P.R. Discussion Papers.
  7. repec:cup:cbooks:9780521002882 is not listed on IDEAS
  8. Bardsen, Gunnar & Eitrheim, Oyvind & Jansen, Eilev S. & Nymoen, Ragnar, 2005. "The Econometrics of Macroeconomic Modelling," OUP Catalogue, Oxford University Press, number 9780199246502, March.
  9. Rudebusch, Glenn D, 2005. "Assessing the Lucas Critique in Monetary Policy Models," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(2), pages 245-72, April.
  10. Granger, Clive W. J., 2001. "Macroeconometrics - Past and future," Journal of Econometrics, Elsevier, vol. 100(1), pages 17-19, January.
  11. Elena Andreou & Aris Spanos, 2003. "Statistical Adequacy and the Testing of Trend Versus Difference Stationarity," Econometric Reviews, Taylor & Francis Journals, vol. 22(3), pages 217-237, January.
  12. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of Simple Monetary Policy Rules under Model Uncertainty," NBER Working Papers 6570, National Bureau of Economic Research, Inc.
  13. Peter Isard & Douglas Laxton & Ann-Charlotte Eliasson, 1999. "Simple Monetary Policy Rules Under Model Uncertainty," Computing in Economics and Finance 1999 841, Society for Computational Economics.
  14. N. Gregory Mankiw, 1989. "Real Business Cycles: A New Keynesian Perspective," NBER Working Papers 2882, National Bureau of Economic Research, Inc.
  15. Nymoen, Ragnar, 1989. " Wages and the Length of the Working Day. An Empirical Test Based on Norwegian Quarterly Manufacturing Data," Scandinavian Journal of Economics, Wiley Blackwell, vol. 91(3), pages 599-612.
  16. Jon Faust & Dale W. Henderson, 2004. "Is inflation targeting best-practice monetary policy?," International Finance Discussion Papers 807, Board of Governors of the Federal Reserve System (U.S.).
  17. Timothy Cogley & Thomas J. Sargent, 2005. "The conquest of US inflation: Learning and robustness to model uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 528-563, April.
  18. Smets, Frank, 2003. "Maintaining price stability: how long is the medium term?," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1293-1309, September.
  19. Sack, Brian & Wieland, Volker, 2000. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 205-228.
  20. Laurence H. Meyer, 2004. "Practical problems and obstacles to inflation targeting," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 151-160.
  21. Granger, Clive W. J., 1992. "Fellow's opinion: Evaluating economic theory," Journal of Econometrics, Elsevier, vol. 51(1-2), pages 3-5.
  22. Neil R. Ericsson & John S. Irons, 1995. "The Lucas critique in practice: theory without measurement," International Finance Discussion Papers 506, Board of Governors of the Federal Reserve System (U.S.).
  23. Lars Peter Hansen & Thomas J. Sargent, 2001. "Acknowledging Misspecification in Macroeconomic Theory," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(3), pages 519-535, July.
  24. Driffill, John & Rotondi, Zeno, 2004. "Monetary Policy and Lexicographic Preference Ordering," CEPR Discussion Papers 4247, C.E.P.R. Discussion Papers.
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