Monetary Policy Indeterminacy and Identification Failures in the U.S.: Results from A Robust Test

Abstract

SummaryWe propose a novel identification‐robust test for the null hypothesis that an estimated New Keynesian model has a reduced form consistent with the unique stable solution against the alternative of sunspot‐driven multiple equilibria. Our strategy is designed to handle identification failures as well as the misspecification of the relevant propagation mechanisms. We invert a likelihood ratio test for the cross‐equation restrictions (CER) that the New Keynesian system places on its reduced‐form solution under determinacy. If the CER are not rejected, sunspot‐driven expectations can be ruled out from the model equilibrium and we accept the structural model. Otherwise, we move to a second‐step and invert an Anderson and Rubin‐type test for the orthogonality restrictions (OR) implied by the system of structural Euler equations. The hypothesis of indeterminacy and the structural model are accepted if the OR are not rejected. We investigate the finite‐sample performance of the suggested identification‐robust two‐step testing strategy by some Monte Carlo experiments and then apply it to a New Keynesian AD/AS model estimated with actual US data. In spite of some evidence of weak identification as for the ‘Great Moderation’ period, our results offer formal support to the hypothesis of a switch from indeterminacy to a scenario consistent with uniqueness occurring in the late 1970s. Our identification‐robust full‐information confidence set for the structural parameters computed on the ‘Great Moderation’ regime turns out to be more precise than the intervals previously reported in the literature through ‘limited‐information’ methods. Copyright © 2014 John Wiley & Sons, Ltd.

To sign or not to sign? On the response of prices to financial and uncertainty shocks

“…For the US, the lending rate used in this study is not available before the third quarter in 1986. This starting date also appears reasonable in light of evidence on the Great Moderation, which suggests a structural shift of the economy towards a less volatile regime (see, for example, McConnell and Perez-Quiros, 2000;Arias, Hansen, and Ohanian, 2007;Justiniano and Primiceri, 2008), and the break in the policy conduct with the advent of Paul Volcker as Fed's chairman (see, for example, Clarida, Galí, and Gertler, 2000;Lubik and Schorfheide, 2004;Benati and Surico, 2009;Castelnuovo and Fanelli, 2015). As depicted in Table A.1, most of the time series are drawn from standard sources.…”

Solving and Estimating Indeterminate DSGE Models

“…The Lubik-Schorfheide approach assumes that the researcher can identify, a priori, determinate and indeterminate regions of the parameter space. For models where that is difficult or impossible, Fanelli (2012) and Castelnuovo and Fanelli (2014) propose an alternative method that may be used to test the null hypothesis of determinacy.…”

“…Farmer and Guo (1995) took up that challenge by studying a model where indeterminacy arises from a technology with increasing returns-to-scale, and Lubik and Schorfheide (2004), developed methods for distinguishing determinate from indeterminate models which they applied to a New-Keynesian mone-tary model. There is a growing body of literature, see, for example, Belaygorod and Dueker (2009); Bhattarai et al (2012); Fanelli (2012); Castelnuovo and Fanelli (2014); Hirose (2011); Zheng and Guo (2013); Bilbiie and Straub (2013), that directly tackles the econometric challenges posed by indeterminacy. This literature offers the possibility for the theoretical work, surveyed in Benhabib and Farmer (1999), to be directly compared with conventional classical and new-Keynesian approaches in which equilibria are assumed to be locally unique.…”

Solving and estimating indeterminate DSGE models

“…Farmer and Guo (1995) took up that challenge by studying a model where indeterminacy arises from a technology with increasing returns-to-scale, and Lubik and Schorfheide (2004), developed methods for distinguishing determinate from indeterminate models which they applied to a New-Keynesian mone-tary model. There is a growing body of literature, see, for example, Belaygorod and Dueker (2009); Bhattarai et al (2012); Fanelli (2012); Castelnuovo and Fanelli (2014); Hirose (2011); Zheng and Guo (2013); Bilbiie and Straub (2013), that directly tackles the econometric challenges posed by indeterminacy. This literature offers the possibility for the theoretical work, surveyed in Benhabib and Farmer (1999), to be directly compared with conventional classical and new-Keynesian approaches in which equilibria are assumed to be locally unique.…”