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Discussion of Marco del Negro and

Frank Schorfheide’“Monetary Policy Analysis with

Potentially Misspecified Models”Ramon Marimon

Universitat Pompeu Fabra & CREi, Barcelona

(visiting Ente Einaudi and Luiss University, Rome)

Monetary policy and imperfect knowledge

ECB conference 

Würzburg, 14-15 October 2004

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A Discussion in honor of The 2004 Nobel Laureates in

Economic Science!Finn E. Kydland &Edward C. Prescott

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What

                                would say?

  “padre teorico della Banca Centrale Europea”(Sole 24 Ore, Ocotber 12, 2004) 

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The 1st that Ed would say is…

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With probability .73 the discussion would end here!

Today the “efficient lottery” results in continuation…

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The 2nd

Of course, 1995 Nobel Laureate Robert Lucas is right,

but the issue [between DSGE models and VARs]is not the Lucas critique

It’s, as 1975 Nobel Laureate Tjalling Koopmans’s, said “avoid measurement without theory”

and [Ed adds] “constraint theory by data & facts”“the ‘minimal SVAR theory’ is not

a beautiful theory (as RBC can be)”

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“What is a beautiful theory?”1979 Physics Nobel Laureate Steven Weinberg

asks, and says(proper Nobel Laureates only quote other Nobel Laureates!)

“Simplicity is part of what I mean by beauty, but it is a simplicity of ideas...”

“We are on the track of something universal (…) We do not want to discover a theory that is capable of describing all imaginable kinds of force among particles of nature. Rather we hope for a theory that rigidly will allow us to describe only those forces –gravitational, electroweak, and strong– that actually, as it happens, do exist. This kind of rigidity in our physical theories is part of what we recognize as beauty.” (Dreams of a Final Theory)

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Are Del Negro & Schorfheilde building on a “beautiful theory”?

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• In every period a fraction of firms is unable to re-optimize their prices

• Households preferences display habit persistence• The preference shifters …• Households choose capital utilization and pay a cost of utilization• Stochastic disturbance to the price of investment• In every period a fraction of households is unable to re-adjust

their wages• There is a complete set of contingent securities in nominal terms• The central bank follows a nominal interest rate rule• At time T the policymaker seeks to replace the existing policy

rule…

,t tb

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The 3rd:

Progress, don’t disperse!

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The 4th :

• Watch your language!

• What do you mean by ‘complete markets’ here?

• What is your commodity space?

• What monetary/banking model do you have?

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The 5th :

Set an explicit Recursive Dynamic Stochastic General Equilibrium Model!

Derive agents and policy rules as functions of the state variables!Then,

you can talk more properly of amisspecified model

-are we missing a state variable?-are we constraining policy rules?-do agents’ Perceived Law of Motion differ from the Actual Law of Motion? [sorry, this is not Ed’s language!]

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Del Negro & Schorfheilde’ misspecification

DSGE:

Misspecified DSGE:

Is this a DSGE?

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Can we deconstruct?• Where is the misspecification in the original model?• Are we missing a state variable?• Does the AR representation of decision rules require

long lags? “The hyperparameter , determining the length of

the sample scales the variance of the the discrepancy. Large values of , correspond to small model misspecification”

with small you are likely to misspecify your decision rules! (Chari-Kehoe-McGrattan dixit)

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How do Del Negro & Schorfheilde’ proceed?

• “We begin with a direct estimation of the DSGE model using Bayesian techniques…”

• “We will construct a prior that has the property that its density is proportional to the expected likelihood ratio of …”

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The 6th

Calibrate, don’t Bayess!

a Minnesota discussion with will follow

It will be:

truly misspecified

inarticulate and

suddenly interrupted!

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...only understood by

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and Ed, looking

would say

The 7th!

Don’t you have a problem with your Likelihood being too flat?

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and Del Negro & Schorfheilde

• “We conclude that over the range of historical sample the DSGE model is strongly dominated by the DSGE-VARs with intermediate values of indicating that the structural model is to some extent misspecified”

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Ed would say: The 8th

Misspecified or

Mesmerized?

(from an Arizona Sunset)

Why don’t you check first your DSGE-VARs with the data generated by the DSGE as those guys, still at Minnesota, do?

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But Nobel Laureates must behave!(well, some appear in airline comercials, others write non-sense anti-G books!)

The 9th: What’s the point?(Lucas would say: Where is the meat?)

That while the DSGE may recommend a stronger response to inflation movements, the ‘better fit’ (optimal) misspecified DSGE-VAR will not recommend a strong response, when the ‘policymaker’ allows for more feedback from sample information (Scenarios 3 &4)?

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•definitively use “rules rather than discretion”

•follow the scientific method for policy design

•support “economics science” research

(as the Mpls FED!)

The 10th : The ECB should

Finally, being here, the  “ padre teorico della Banca Centrale Europea”

would conclude

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And Ed, the now proper Nobel Laureate,

would say

Thank you!