Economic models are limited by many factors, both theoretical and practical. Three fundamental hurdles of economic models are the presence of parameter instabilities, weak identification and mis-specification. "Parameter instabilities" in a model are when the models' parameters vary over time. For example, the volatility of output growth has increased in the late 1980s; it is unclear whether this increase may be explained by changes in monetary policy, or by changes in the private sector behavior, or simply by unknown causes. If an economic model is compatible with observed data for two different parameter values it is known as "weakly identified;" this implies that, with the available data, the true model of the economy may not be estimated precisely enough. "Mis-specification" means that the economic model used to estimate the impact of economic policies may be a fundamentally incorrect representation of reality. The presence of instabilities, weak identification, or mis-specification may invalidate the results from an estimated model, leading to incorrect conclusions by researchers and to incorrect policy decisions by policy makers.
The recent literature suggests that instabilities, weak identification and mis-specification are widespread phenomena. Clearly, a successful understanding of the economy and the implementation of economic policy in practice depend on understanding the causes of changes in these parameters. They also crucially depend on using reliable models where any weak identification or mis-specification issues have been resolved. As a result, much effort has been devoted to designing new and improved tests to address these issues, and researchers have paid more attention to such tools in their empirical works. However, notwithstanding the recent developments, we still lack methods to identify the exact sources of instabilities, as well as tests that are robust to weak identification and mis-specification, with the result that researchers are currently left with little guidance on how to deal with these issues in practice.
The PIs propose new and useful econometric methods in these realistic and empirically relevant situations. In the first research project, "Identifying the Sources of Instabilities in Macroeconomic Fluctuations", the PIs propose new methods for searching for and detecting the sources of instabilities in the data. The PIs overturn conventional findings by showing that previous results in the literature depend on imposing stability constraints on ad-hoc sets of parameters. In the second research project, "Testing for Weak Identification in Macroeconomic Models", the PIs propose a new test for identification whose novelty is the robustness to the presence of weak identification. In the third research project, "Selection Criteria for IRFME and Other Estimators of DSGE Models", the PIs propose new methodologies that guarantee consistent and efficient estimation of models' parameters even in the presence of mis-specification.
Broader impact: These methodologies will provide practical guidance to applied researchers, economists and central bankers on how to deal with such issues in practice. This proposal describes important economic applications where these methods will be useful. The methods will be shared with practitioners within the scientific community and students alike, and will contribute to understanding the role of instabilities in the economy.
