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

  • Fabio Milani


    (Department of Economics, University of California-Irvine)

  • Ashish Rajbhandari


    (Department of Economics, University of California-Irvine)

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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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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  1. Neiss, Katharine S. & Nelson, Edward, 2003. "The Real-Interest-Rate Gap As An Inflation Indicator," Macroeconomic Dynamics, Cambridge University Press, vol. 7(02), pages 239-262, April.
  2. Paul Levine & Joseph Pearlman & George Perendia & Bo Yang, 2010. "Endogenous Persistence in an Estimated DSGE Model under Imperfect Information," School of Economics Discussion Papers 0310, School of Economics, University of Surrey.
  3. Preston, Bruce, 2005. "Learning about Monetary Policy Rules when Long-Horizon Expectations Matter," MPRA Paper 830, University Library of Munich, Germany.
  4. Schmitt-Grohé, Stephanie & Uribe, Martín, 2009. "What’s News in Business Cycles," CEPR Discussion Papers 7201, C.E.P.R. Discussion Papers.
  5. repec:tpr:qjecon:v:123:y:2008:i:4:p:1415-1464 is not listed on IDEAS
  6. Christoffel, Kai & Warne, Anders & Coenen, Günter, 2010. "Forecasting with DSGE models," Working Paper Series 1185, European Central Bank.
  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, issue Mar.
  8. Sergey Slobodyan & Raf Wouters, 2009. "Learning in an Estimated Medium-Scale DSGE Model," CERGE-EI Working Papers wp396, The Center for Economic Research and Graduate Education - Economics Institute, Prague.
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