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.
The zero lower bound will have a lasting and profound effect on business cycle research. First, because it happened and this eventuality was not much considered previously. Second, because the assumption of symmetry around a steady-state is not defensible any more and linearization cannot be justified. And third, because the data is also “tainted” and one needs to be extra-careful in dealing with it now. This paper is a good example of this third point.