By Yasuo Hirose and Atsushi Inoue
This paper examines how and to what extent parameter estimates can be biased in a dynamic stochastic general equilibrium (DSGE) model that omits the zero lower bound (ZLB) constraint on the nominal interest rate. Our Monte Carlo experiments using a standard sticky-price DSGE model show that no significant bias is detected in parameter estimates and that the estimated impulse response functions are quite similar to the true ones. However, as the probability of hitting the ZLB increases, the parameter bias becomes larger and therefore leads to substantial differences between the estimated and true impulse responses. It is also demonstrated that the model missing the ZLB causes biased estimates of structural shocks even with the virtually unbiased parameters.
Beyond the issue that this paper highlights, we should remember that for any estimation that covers the past decade we likely cannot use the standard methods that assume symmetric responses for positive and negative deviations from the mean in the data. I suspect we are going to see a lot of lousy regressions that blindly throw variables into a non-structural estimation and pretend to get reliable results.