Expectation Formation and Monetary DSGE Models: Beyond the Rational Expectations Paradigm

Abstract

Empirical work in macroeconomics almost universally relies on the hypothesis of rational expectations. This paper departs from the literature by considering a variety of alternative expectations formation models. We study the econometric properties of a popular New Keynesian monetary DSGE model under different expectational assumptions: the benchmark case of rational expectations, rational expectations extended to allow for 'news' about future shocks, near-rational expectations and learning, and observed subjective expectations from surveys. The results show that the econometric evaluation of the model is extremely sensitive to how expectations are modeled. The posterior distributions for the structural parameters significantly shift when the assumption of rational expectations is modified. Estimates of the structural disturbances under different expectation processes are often dissimilar. The modeling of expectations has important effects on the ability of the model to fit macroeconomic time series. The model achieves its worse fit under rational expectations. The introduction of news improves fit. The best-fitting specifications, however, are those that assume learning. Expectations also have large effects on forecasting. Survey expectations, news, and learning all work to improve the model's one-step-ahead forecasting accuracy. Rational expectations, however, dominate over longer horizons, such as one-year ahead or beyond.

News Driven Business Cycles: Insights and Challenges

“…Lamla, Lein, and Sturm [2007] identify news shocks making use of the business tendency surveys of the German Ifo Institute. Milani and Rajbhandari [2012b] exploit information from the term structure of survey expectations to identify news shocks in a DSGE model with rational expectations. Recently, Angeletos, Collard, and Dellas [2013] and Fève and Guay [2013] have made use of consumer confidence data in order to disentangle technological news from "sentiment" shocks.…”

“…Perendia and Tsoukis [2012] incorporate a fiscal rule in the Smets and Wouters [2007] model and study the impact of news shocks, modeled as revisions of expectations in the consumption Euler equation. Milani and Rajbhandari [2012a] run a horserace in a DSGE model in which expectations are either rational with or without news, formed with adaptive learning or taken from observed survey. See Milani [2012] for a survey of the various way of modeling expectations in DSGE models.…”

Relaxing Rational Expectations

“…The assumption that agents learn about the functioning of the economy over time as they observe more data has been explored by many authors (e.g. Evans and Honkapohja (2001), Milani (2007), and Milani and Rajbhandari (2012)). Under this assumption, agents act as econometricians: they observe only a history of observations, and form beliefs over the laws of motion for those variables which change over time as the history of observations grows.…”

“…It is important to stress what the estimation identifies: it is the deviation from rational expectations favored while maintaining the rest of a specific model as given. In contrast to other papers, such as Milani (2007) and Milani and Rajbhandari (2012) which discuss how the estimates of the the remainder of the "deep" parameters (not governing expectations) change when expectations are no longer REE, I take the parameters not governing expectations as given. If the rest of the model is mis-specified, the data will seize upon the reduced-form specification of expectations to push against that misspecification as well.…”

Observed expectations, news shocks, and the business cycle

“…The use of survey expectations to inform and constrain the estimation of rational expectations models has been advocated, for example, in Milani (2012a) and Milani and Rajbhandari (2012). adjustment decisions are subject to adjustment costs and the capacity utilization rate can be varied depending on the rental rate of capital.…”