Structural Estimation of the New-Keynesian Model: A Formal Test of Backward- and Forward-Looking Behavior

This chapter analyzes the empirical relationship between the pricesetting/consumption 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 is used to compare the fit of two competing specifications in the New-Keynesian Phillips Curve (NKPC) and the IS equation, that is, backward- and forward-looking behavior. 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 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, that is, the NKM with purely forward-looking behavior and its hybrid variant are equivalent. Monte Carlo experiments investigate the validity of chosen moment conditions and the finite sample properties of the chosen estimation methods. Finally, the empirical performance of the formal test is discussed along the lines of the Akaike's and the Bayesian information criterion.