Misspecification and Expectations Correction in New Keynesian DSGE Models

This paper focuses on the dynamic misspecification that characterizes the class of small-scale New Keynesian models currently used in monetary and business cycle analysis, and provides a remedy for the typical difficulties these models have in accounting for the rich contemporaneous and dynamic correlation structure of the data. We suggest using a statistical model for the data as a device through which it is possible to adapt the econometric specification of the New Keynesian model such that the risk of omitting important propagation mechanisms is kept under control. A pseudo-structural form is built from the baseline system of Euler equations by forcing the state vector of the system to have the same dimension as the state vector characterizing the statistical model. The pseudo-structural form gives rise to a set of cross-equation restrictions that do not penalize the autocorrelation structure and persistence of the data. Standard estimation and evaluation methods can be used. We provide an empirical illustration based on USA quarterly data and a small-scale monetary New Keynesian model.