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

  • Stephen J. Cole (a1) and Fabio Milani (a2)
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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Corresponding author
Address correspondence to: Fabio Milani, Department of Economics, University of California, Irvine, 3151 Social Science Plaza, Irvine, CA 92697-5100, USA; e-mail: fmilani@uci.edu; URL: http://www.socsci.uci.edu/~fmilani.
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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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Macroeconomic Dynamics
  • ISSN: 1365-1005
  • EISSN: 1469-8056
  • URL: /core/journals/macroeconomic-dynamics
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