Generalized Adjustment Costs and Macro Dynamics: Specification and System Estimation of a Small-Scale Model of the US Economy

Antulio Bomfim and John Williams - Federal Reserve Board

To be useful for policy analysis, a macroeconomic model must be consistent with historical experience and reasonably depict the channels by which policy decisions affect the economy. Each requirement is necessary, but not sufficient on its own. A model that is constructed strictly from fundamentals cannot be relied on for real-world policy decisions if it does not fit the data. Likewise, a model that fails to capture the private sector's responses to changes in policy is of questionable value, even if it has a good historical fit. Achieving both goals has thus far been a difficult task. Equilibrium models have tended to favor theory over fit; models based on estimated reduced forms do the opposite. In this paper, we use a small-scale macro model based on a generalized adjustment cost approach that makes progress in achieving both objectives: The model is built upon intertemporal optimization and rational expectations and fits the data reasonably well.

Scheduled for Session 2.2 Modeling Economic Dynamics And Adjustment Costs