Issues in Estimating New Keynesian Phillips Curves in the Presence of Unknown Structural Change

Many papers which have estimated models with forward looking expectations have reported that the magnitude of the coefficients of the expectations term is very large when compared with the effects coming from past dynamics. This has sometimes been regarded as implausible and led to the feeling that the expectations coefficient is biased upwards. A relatively general argument that has been advanced is that the bias could be due to structural changes in the means of the variables entering the structural equation. An alternative explanation is that the bias comes from weak instruments. In this paper we investigate the issue of upward bias in the estimated coefficients of the expectations variable based on a model where we can see what causes the breaks and how to control for them. We conclude that weak instruments are the most likely cause of any bias and note that structural change can affect the quality of instruments. We look at some empirical work in Castle et al. (2011) on the NK Phillips curve in the Euro Area. We assess whether the smaller coefficient on expectations that Castle et al. (2011) note when an allowance is made for structural change is due to weak instruments or to specification issues. Our finding suggests that it is probably a consequence of weak instruments