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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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  11. Jordi Galí & Mark Gertler, 1998. "Inflation dynamics: A structural econometric analysis," Economics Working Papers 341, Department of Economics and Business, Universitat Pompeu Fabra.
  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. 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.
  14. King, Robert G & Watson, Mark W, 1998. "The Solution of Singular Linear Difference Systems under Rational Expectations," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 1015-26, November.
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  18. James H. Stock & Motohiro Yogo, 2002. "Testing for Weak Instruments in Linear IV Regression," NBER Technical Working Papers 0284, National Bureau of Economic Research, Inc.
  19. Peter N. Ireland, 1999. "Sticky-Price Models of the Business Cycle: Specification and Stability," Boston College Working Papers in Economics 426, Boston College Department of Economics.
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  22. 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.
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  24. Argia M. Sbordone, 2005. "Do expected future marginal costs drive inflation dynamics?," Staff Reports 204, Federal Reserve Bank of New York.
  25. Goffe William L., 1996. "SIMANN: A Global Optimization Algorithm using Simulated Annealing," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 1(3), pages 1-9, October.
  26. James M. Nason & Gregor W. Smith, 2005. "Identifying the New Keynesian Phillips Curve," Working Papers 1026, Queen's University, Department of Economics.
  27. Stock, James H & Wright, Jonathan H & Yogo, Motohiro, 2002. "A Survey of Weak Instruments and Weak Identification in Generalized Method of Moments," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(4), pages 518-29, October.
  28. John M. Roberts, 1994. "Is inflation sticky?," Working Paper Series / Economic Activity Section 152, Board of Governors of the Federal Reserve System (U.S.).
  29. Jeffrey Fuhrer & George Moore & Scott Schuh, 1993. "Estimating the linear-quadratic inventory model: maximum likelihood versus generalized method of moments," Finance and Economics Discussion Series 93-11, Board of Governors of the Federal Reserve System (U.S.).
  30. 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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