Structural estimation of the New-Keynesian Model: a formal test of backward- and forward-looking expectations

This paper attempts to uncover the empirical relationship between the price-setting/consumer behavior and the sources of persistence in inflation and output. First, a small-scale New-Keynesian model (NKM) is examined using the method of moment and maximum likelihood estimators with US data from 1960 to 2007. Then a formal test compares the fit of two competing specifications in the New-Keynesian Phillips Curve (NKPC) and the IS equation; i.e., forward- or backward-looking expectations. Accordingly, the inclusion of a lagged term in the NKPC and the IS equation improves the fit of the model while offsetting the influence of inherited and extrinsic persistence; it is shown that intrinsic persistence plays a major role in approximating the inflation and output dynamics for the Great Inflation period. However, the null hypothesis cannot be rejected at the 5% level for the Great Moderation period; i.e. the NKM of purely forward-looking behavior and its hybrid variant are equivalent. Monte Carlo experiments illustrate the validity of the chosen moment conditions and the finite sample properties of classical estimation methods. Finally, the empirical performance of model selection methods is investigated using the Akaike’s and the Bayesian information criterion.