How can parameter estimates be biased in a dynamic stochastic general equilibrium model that omits nonlinearity in the economy? To answer this question, we simulate data from a fully nonlinear New Keynesian model with the zero lower bound constraint and estimate a linearized version of the model. Monte Carlo experiments show that significant biases are detected in the estimates of monetary policy parameters and the steady-state inflation and real interest rates. These biases arise mainly from neglecting the zero lower bound constraint rather than linearizing equilibrium conditions. With fixed parameters, the variance-covariance matrix and impulse response functions of observed variables implied by the linearized model substantially differ from those implied by its nonlinear counterpart. However, we find that the biased estimates of parameters in the estimated linear model can make most of the differences small.
This paper investigates how and to what extent nonlinearities, including the zero lower bound on the nominal interest rate, affect the estimate of the natural rate of interest in a dynamic stochastic general equilibrium model with sticky prices and wages. The estimated natural rate of interest in a nonlinear model is substantially different from that in its linear counterpart because of a contractionary effect of the zero lower bound. Price and wage dispersion, from which a linear model abstracts, play a minor role in identifying the natural rate.
We explore how outcomes of optimal monetary policy with loose commitment (Schaumburg and Tambalotti, 2007; Debortoli and Nunes, 2010) with the non-reoptimization probability of α can be interpretable as outcomes of deeper optimal policy under sustainable plans (Chari and Kehoe, 1990) with N-period punishment. In a standard monetary-policy framework, we show that, for any sufficiently high value of α, there exists an integer N such that impulse responses to the cost-push shock under each policy are similar to each other.
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