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THE MISSPECIFICATION OF EXPECTATIONS IN NEW KEYNESIAN MODELS: A DSGE-VAR APPROACH

Published online by Cambridge University Press:  11 July 2017

Stephen J. Cole
Affiliation:
Marquette University
Fabio Milani
Affiliation:
University of California, Irvine
Corresponding
E-mail address:

Abstract

This paper tests the ability of New Keynesian models to match the data regarding a key channel for monetary transmission: the dynamic interactions between macroeconomic variables and their corresponding expectations. We exploit survey expectations data and adopt a dynamic stochastic general equilibrium (DSGE)-VAR approach to assess the extent and sources of model misspecification. The results point to serious misspecification in the expectations-formation side of the DSGE model. The rational expectations hypothesis is primarily responsible for the model's failure to capture the co-movements between observed macroeconomic expectations and realizations. Alternative models of expectations formation help partially reconcile the New Keynesian model with the data.

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Copyright
Copyright © Cambridge University Press 2017 

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Footnotes

We would like to thank the journal editor William Barnett, an associate editor, and two anonymous referees, for helpful comments and suggestions that substantially improved the paper.

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