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

  • André Kurmann

    (Université du Québec à Montréal, CIRPÉE)

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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File URL: http://econwpa.repec.org/eps/mac/papers/0409/0409028.pdf
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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
Date of revision:
Handle: RePEc:wpa:wuwpma:0409028
Note: Type of Document - pdf; pages: 37
Contact details of provider: Web page: http://econwpa.repec.org

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  10. James M. Nason & Gregor W. Smith, 2008. "Identifying the new Keynesian Phillips curve," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 23(5), pages 525-551.
  11. Roberts John M., 2005. "How Well Does the New Keynesian Sticky-Price Model Fit the Data?," The B.E. Journal of Macroeconomics, De Gruyter, vol. 5(1), pages 1-39, September.
  12. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
  13. Jordi Gali & Mark Gertler, 2000. "Inflation Dynamics: A Structural Econometric Analysis," NBER Working Papers 7551, National Bureau of Economic Research, Inc.
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  17. Roberts, John M., 1997. "Is inflation sticky?," Journal of Monetary Economics, Elsevier, vol. 39(2), pages 173-196, July.
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  22. 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.
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