Determinacy, indeterminacy and dynamic misspecification in linear rational expectations models

This paper proposes a testing strategy for the null hypothesis that a multivariate linear rational expectations (LRE) model may have a unique stable solution (determinacy) against the alternative of multiple stable solutions (indeterminacy). The testing problem is addressed by a misspecification-type approach in which the overidentifying restrictions test obtained from the estimation of the system of Euler equations of the LRE model through the generalized method of moments is combined with a likelihood-based test for the cross-equation restrictions that the model places on its reduced form solution under determinacy. The resulting test has no power against a particular class of indeterminate equilibria, hence the non rejection of the null hypothesis can not be interpreted conclusively as evidence of determinacy. On the other hand, this test (i) circumvents the nonstandard inferential problem generated by the presence of the auxiliary parameters that appear under indeterminacy and that are not identifiable under determinacy, (ii) does not involve inequality parametric restrictions and hence the use of nonstandard inference, (iii) is consistent against the dynamic misspecification of the LRE model, and (iv) is computationally simple. Monte Carlo simulations show that the suggested testing strategy delivers reasonable size coverage and power against dynamic misspecification in finite samples. An empirical illustration focuses on the determinacy/indeterminacy of a New Keynesian monetary business cycle model of the US economy. (C) 2012 Elsevier B.V. All rights reserved.