Mis-specified Forecasts and Myopia in an Estimated New Keynesian Model

Abstract

The paper considers a New Keynesian framework in which agents form expectations based on a combination of mis-specified forecasts and myopia. The proposed expectations formation process is found to be consistent with all three empirical facts on consensus inflation forecasts, namely, that forecasters under-react to ex-ante forecast revisions, that forecasters over-react to recent events, and that the response of forecast errors to a shock initially under-shoots but then over-shoots. The paper then derives the general equilibrium solution consistent with the proposed expectations formation process and estimates the model with likelihood-based Bayesian methods, yielding three novel results: (i) The data strongly prefer the combination of autoregressive mis-specified forecasting rules and myopia over other alternatives; (ii) The best fitting expectations formation process for both households and firms is characterized by high degrees of myopia and simple AR(1) forecasting rules; (iii) Frictions such as habit in consumption, which are typically necessary for models with Full-information Rational Expectations, are significantly less important, because the proposed expectations generate substantial internal persistence and amplification to exogenous shocks. Simulated inflation expectations data from the estimated general equilibrium model reflect the three empirical facts on forecasting data.