DP12130 A Generalized Approach to Indeterminacy in Linear Rational Expectations Models

Author(s): Francesco Bianchi, Giovanni Nicolò
Publication Date: July 2017
Keyword(s): Bayesian methods., General Equilibrium, Indeterminacy, Solution method
JEL(s): C19, C51, C62, C63
Programme Areas: International Macroeconomics and Finance, Monetary Economics and Fluctuations
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=12130

We propose a novel approach to deal with the problem of indeterminacy in Linear Rational Expectations models. The method consists of augmenting the original model with a set of auxiliary exogenous equations that are used to provide the adequate number of explosive roots in presence of indeterminacy. The solution in this expanded state space, if it exists, is always determinate, and is identical to the indeterminate solution of the original model. The proposed approach accommodates determinacy and any degree of indeterminacy, and it can be implemented even when the boundaries of the determinacy region are unknown. Thus, the researcher can estimate the model by using standard packages without restricting the estimates to a certain area of the parameter space. We apply our method to simulated and actual data from a prototypical New-Keynesian model for both regions of the parameter space. We show that our method successfully recovers the true parameter values independent of the initial values.