Testing Steady-State Restrictions of Linear Rational Expectations Models when Data are Highly Persistent

Authors


  • I gratefully acknowledge the financial support provided by the research department of the Bank of Finland to carry out this work. The paper has benefited from numerous valuable comments by two anonymous referees, Søren Johansen, Katarina Juselius, Moshe Kim, Antti Ripatti, and the participants of the department's research seminars. I bear sole responsibility for all remaining errors and omissions.

Abstract

Steady-state restrictions are commonly imposed on highly persistent variables to achieve stationarity prior to confronting rational expectations models with data. However, the resulting steady-state deviations are often surprisingly persistent indicating that some aspects of the underlying theory may be empirically problematic. This paper discusses how to formulate steady-state restrictions in rational expectations models with latent forcing variables and test their validity using cointegration techniques. The approach is illustrated by testing steady-state restrictions for alternative specifications of the New Keynesian model and shown to be able to discriminate between different assumptions on the sources of the permanent shocks.

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