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Faculty of Economics

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Pesaran, H. and Smith, R.

Tests of Policy Ineffectiveness in Macroeconometrics

CWPE1415

Abstract: This paper proposes tests of policy ineffectiveness in the context of macroeconometric rational expectations models. It is assumed that there is a policy intervention that takes the form of changes in the parameters of a policy rule, and that there are sufficient observations before and after the intervention. The test is based on the difference between the realisations of the outcome variable of interest and counterfactuals based on no policy intervention, using only the pre-intervention parameter estimates, and in consequence the Lucas Critique does not apply. The paper develops tests of policy ineffectiveness for a full structural model, with and without exogenous, policy or non-policy, variables. Asymptotic distributions of the proposed tests are derived both when the post intervention sample is fixed as the pre-intervention sample expands, and when both samples rise jointly but at different rates. The performance of the test is illustrated by a simulated policy analysis of a three equation New Keynesian Model, which shows that the test size is correct but the power may be low unless the model includes exogenous variables, or if the policy intervention changes the steady states, such as the inflation target.

Keywords: Counterfactuals, policy analysis, policy ineffectiveness test, macroeconomics

JEL Codes: C18 C54 E65,

Author links: M. Hashem Pesaran  

PDF: http://www.econ.cam.ac.uk/research-files/repec/cam/pdf/cwpe1415.pdf

Open Access Link: https://doi.org/10.17863/CAM.4946