1. 1 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

2. 2 A Discussion in honor of The 2004 Nobel Laureates in Economic Science! Finn E. Kydland & Edward C. Prescott

3. 3 What would say? padre teorico della Banca Centrale Europea (Sole 24 Ore, Ocotber 12, 2004)

4. 4 The 1 st that Ed would say is…

5. 5

6. 6 With probability.73 the discussion would end here! Today the efficient lottery results in continuation…

7. 7 The 2 nd Of course, 1995 Nobel Laureate Robert Lucas is right, but the issue [between DSGE models and VARs] is not the Lucas critique Its, as 1975 Nobel Laureate Tjalling Koopmanss, 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)

8. 8 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)

9. 9 Are Del Negro & Schorfheilde building on a beautiful theory?

10. 10 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…

11. 11 The 3 rd : Progress, dont disperse!

12. 12 The 4 th : Watch your language! What do you mean by complete markets here? What is your commodity space? What monetary/banking model do you have?

13. 13 The 5 th : 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 a misspecified 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 Eds language!]

14. 14 Del Negro & Schorfheilde misspecification DSGE: Misspecified DSGE: Is this a DSGE?

15. 15 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)

16. 16 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 …

17. 17 The 6 th Calibrate, dont Bayess! a Minnesota discussion with will follow It will be: truly misspecified inarticulate and suddenly interrupted!

18. 18...only understood by

19. 19 and Ed, looking would say The 7 th ! Dont you have a problem with your Likelihood being too flat?

20. 20 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

21. 21 Ed would say: The 8 th Misspecified or Mesmerized ? (from an Arizona Sunset) Why dont you check first your DSGE-VARs with the data generated by the DSGE as those guys, still at Minnesota, do?

22. 22 But Nobel Laureates must behave! (well, some appear in airline comercials, others write non-sense anti-G books!) The 9 th : Whats 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)?

23. 23

24. 24 definitively use rules rather than discretion follow the scientific method for policy design support economics science research (as the Mpls FED!) The 10 th : The ECB should Finally, being here, the padre teorico della Banca Centrale Europea would conclude

25. 25 And Ed, the now proper Nobel Laureate, would say Thank you!