Zero Lower Bound and Parameter Bias in an Estimated DSGE Model
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 constraint on the nominal interest rate. Our experiments show that most of the parameter estimates in a standard sticky-price DSGE model are not biased although some biases are detected in the estimates of the monetary policy parameters and the steady-state real interest rate. Nevertheless, in our baseline experiment, these biases are so small that the estimated impulse response functions are quite similar to the true impulse response functions. However, as the probability of hitting the zero lower bound increases, the biases in the parameter estimates become larger and can therefore lead to substantial differences between the estimated and true impulse responses.
Dynamic stochastic general equilibrium (DSGE) models have become a prominent tool for policy analysis. In particular, following the development of Bayesian estimation and evaluation techniques, estimated DSGE models have been extensively used by a range of policy institutions, including central banks. At the same time, the zero lower bound constraint on the nominal interest rates has been a primary concern for policymakers. Much work has been devoted to understand how the economy works and how policy should be conducted in the presence of this constraint from a theoretical perspective. However, empirical studies that estimate DSGE models including the interest-rate lower bound are still scarce because of computational difficulties in the treatment of nonlinearity arising from the bound, and hence most practitioners continue to estimate linearized DSGE models without explicitly considering the lower bound.