Estimating New Keynesian Phillips Curve Single Equation vs. DSGE Approach

Masaryk University
Faculty of Economics and Administration
Field of Study:
Mathematical and Statistical Methods in Economics
master thesis
Estimating New Keynesian

Phillips Curve: Single Equation
vs. DSGE Approach
Odhad Novokeynesiánské Phillipsovy křivky:

jednorovnicový vs. DSGE přı́stup
Supervisor: Author:
Ing. Daniel Němec Bc. Petr Ševčı́k
April 2010
Author: Petr Ševčı́k
Thesis title: Estimating New Keynesian Phillips Curve:
Single Equation vs. DSGE Approach
Thesis title in Czech: Odhad novokeynesiánské Phillipsovy křivky:
jednorovnicový vs. DSGE přı́stup
Program: Quantitative Methods in Economy
Field: Mathematical and Statistical Methods in Economics
Supervisor: Ing. Daniel Němec
Year of defence: 2010
Annotation
The thesis deals with the analysis of inflation dynamics in the Czech Re-
public. It is studied in the context of the New Keynesian Phillips Curve, in
particular, its hybrid version. The curve is estimated in two ways. First, the
single equation method—the generalized method of moments—is applied.
Then, the NKPC is set in a simple DSGE model. This system of equations
is estimated via the Bayesian method.
Annotation in Czech
Diplomová práce se zabývá analýzou inflačnı́ dynamiky v České republice. Ta

je studována v kontextu Novokeynesiánské Phillipsovy křivky, konkrétně jejı́
hybridnı́ verze. Křivka je odhadována dvojı́m způsobem. Práce se nejdřı́ve
zabývá jednorovnicovým přı́stupem - k odhadu je použita zobecněná metoda
momentů. Poté je NKPC zasazena do jednoduchého DSGE modelu. Tento
systém rovnic je poté odhadován bayesiánskými technikami.
Keywords
New Keynesian Phillips Curve, generalized method of moments, DSGE, Ba-

yesian approach, Metropolis-Hastings algorithm
Klı́čová slova
Novokeynesiánská Phillipsova křivka, zobecněná metoda momentů, DSGE,

bayesiánský přı́stup, Metropolis-Hastings algoritmus
Acknowledgements:
I would like to thank my supervisor Daniel Němec for numerous on-line and
in-person discussions we had during the process of making this text. These
discussions were invaluable and helped improve this thesis substantially, es-
pecially its graphical aspect.
I declare that I have written this thesis independently under the supervision
of Daniel Němec and that I have cited all the used literature in the Bibliog-
raphy.
April 25, 2010 in Brno .....................................

author’s own signature
Contents
Introduction 7
1 Single Equation Approach 10

1.1 Hybrid New Keynesian Phillips Curve . . . . . . . . . . . . . . 10
1.2 Econometric Hybrid New Keynesian Phillips Curve . . . . . . 12
1.3 Generalized Method of Moments . . . . . . . . . . . . . . . . . 16
1.4 Estimation Results . . . . . . . . . . . . . . . . . . . . . . . . 21
1.4.1 Instrumental and Proxy Variables . . . . . . . . . . . . 22
1.4.2 Empirical Results . . . . . . . . . . . . . . . . . . . . . 24
1.4.3 Problem of Omitted Dynamics . . . . . . . . . . . . . . 32
1.4.4 Weak Identification Robust Method . . . . . . . . . . . 41
2 DSGE Approach 47
2.1 Simple DSGE Model . . . . . . . . . . . . . . . . . . . . . . . 47
2.2 The Bayesian Estimation . . . . . . . . . . . . . . . . . . . . . 49
2.3 Estimation Results . . . . . . . . . . . . . . . . . . . . . . . . 52
Conclusion 59
Bibliography 64
A DSGE Estimation Figures 65

List of Tables
1.1 GMM estimation using q-o-q CPI inflation . . . . . . . 25

1.2 GMM estimation using q-o-q IPD inflation . . . . . . . 28
1.3 GMM estimation using y-o-y CPI inflation . . . . . . . 29
1.4 GMM estimation using y-o-y IPD inflation . . . . . . . 31
1.5 GMM estimation using q-o-q CPI inflation (three lags
of inflation added) . . . . . . . . . . . . . . . . . . . . . . . 35
1.6 GMM estimation using q-o-q IPD inflation (three lags
1.7 GMM estimation using y-o-y CPI inflation (three lags
1.8 GMM estimation using y-o-y IPD inflation (three lags
2.1 Bayesian estimation using q-o-q CPI inflation . . . . . . 54

2.2 Bayesian estimation using q-o-q IPD inflation . . . . . . 55
2.3 Bayesian estimation using y-o-y CPI inflation . . . . . . 56
2.4 Bayesian estimation using y-o-y IPD inflation . . . . . . 57
Introduction
Short-run inflation dynamics is one of the most debated topics in macroeco-

nomics. This dynamics is usually analyzed using the so-called Phillips curve.
Its origins reach to the end of the 1950s when A. W. Phillips described a
negative empirical relationship between nominal wage inflation and unem-
ployment in the United Kingdom (Romer, 2006). Similar empirical relation-
ship between price inflation and unemployment was later found in the data
as well and this seemingly stable trade-off relationship was soon employed
by the Keynesian policymakers.
This approach to inflation was criticized at the end of the 60s by Fried-
man and Phelps (Romer, 2006). These two authors stated that the trade-off
relationship between inflation and unemployment works only in the short
run and the reactions of economic agents secure that the unemployment rate
returns to its “natural” rate in the long run. Mathematically speaking, the
original Phillips curve describing the downward-sloping relationship between
inflation and unemployment became a relationship where inflation depended
on the deviation of the unemployment rate from its natural rate (unemploy-
ment rate gap) and on the inflation expectations (Rudd and Whelan, 2005).
These expectations were formed adaptively, meaning they were based on the
past actual inflation. This would transform our Phillips curve into an equa-
tion where inflation would depend on its past values and unemployment rate
gap.
The journey towards the modern Phillips curve has begun with the cri-
tique of Sargent and Lucas in the early 70s. In their hypothesis of rational
expectations, agents’ behaviour is based not only on the past information but
on all available relevant information, including past, current information and
also expert predictions of the future. Individuals create their expectations
in such manner that they can not be systematically wrong and the overall
expectation is accurate. Technically speaking, this means that subjective ex-
pectations of agents are equal to the conditional expected value based on the
relevant currently available information (Beneš, 2000).
This rational expectations hypothesis, as a widely accepted concept in
8 Introduction
contemporary economics, was used to transform the Phillips curve once again
and the so-called New Keynesian Phillips Curve (henceforth NKPC) has been
set up. NKPC, unlike the previous versions of the curve, is derived from
microeconomic foundations where monopolistically competitive firms may
adjust their prices with respect to the expected marginal cost.
But like its predecessors, also NKPC was econometrically confronted with
data and not very convincing results led Galı́ and Gertler (1999) to come up
with a “hybrid” NKPC. In this version of Phillips curve, inflation depends
on its expected value, marginal cost and also lagged inflation. With new
hypothesis about the short-run inflation dynamics in hand, econometricians
started to test its validity. Mixed results from these estimations have sparked
an ongoing debate about the soundness of the concept.
Analysis of the dynamics of inflation in the Czech Republic using estima-
tion of the hybrid NKPC and analysis of some of the consequent estimation
issues is the subject of this thesis.
In particular, we want to find out statistical difference between different
inflation measures, i.e. does inflation dynamics depend on whether it is mea-
sured via consumer price index (CPI) or implicit price deflator (IPD) or as
quarter-over-quarter or year-over-year indicator? Another issue, we focus on
in this thesis, is the statistical relation between inflation and a real variable.
Since this relation is the pivot of the original Phillips curve, we want to test
whether it holds true even in the NKPC framework. In particular, we test
how the most often used real variable—output gap—performs in NKPC. Last
problem we want to test is the verticality of NKPC. Can we statistically rule
out the long-run trade-off between inflation and a real variable?
To answer such questions we estimate NKPC in two different ways. First,
we estimate NKPC as a single equation using the generalized method of mo-
ments (GMM). We discuss some of the pitfalls that one might face when
estimating NKPC as a single equation. The second approach we employ here
is the Bayesian estimation of NKPC as a part of a very simple dynamic
stochastic general equilibrium (DSGE) model for a closed economy. We an-
alyze how the estimation results change when more information from an
interdependent system is utilized.
The thesis is structured as follows. It is divided in two main chapters.
In chapter 1, we deal with the econometric identification of NKPC as a
single equation. First, we shortly present the theoretical hybrid NKPC and
introduce the econometric formulation of NKPC. Third section covers the
single-equation estimation method—GMM. In section 1.4, the results of the
GMM estimation are discussed. Particular subsections of this section are
devoted to the estimation problems using the single equation approach and
potential estimation improvements are presented and discussed.
9
Subject of chapter 2 is the Bayesian estimation of NKPC as a part of a

basic DSGE model. Section 2.1 lays out the structure of the simple New Key-
nesian model that we use here. Next, the estimation technique—a Bayesian
method using Metropolis-Hastings algorithm—is described. Section 2.3 con-
tains the presentation and discussion of the acquired results.
Chapter 1
Single Equation Approach
Subject of this chapter is the identification of NKPC as a single equation and

analysis of the consequent estimation problems.
Before we proceed to the estimation itself, we are going to introduce the
theoretical hybrid version of NKPC, then its econometric formulation and
finally the estimation technique—GMM—that we employ here. Section 1.4
contains presentation of the estimation results. Therein, we discuss estima-
tion problems we might face during the estimation process (in particular,
weak identification and autocorrelation). In subsections 1.4.3 and 1.4.4, pos-
sible remedies for these problems are introduced and applied.
1.1 Hybrid New Keynesian Phillips Curve

As already mentioned in the Introduction section, NKPC, unlike the tra-
ditional Phillips curve, is derived from microeconomic foundations. Here,
instead of performing a rather tedious task of deriving the hybrid version of
the NKPC, we will only sketch the proceedings in a narrative way.1
As proposed by Galı́ and Gertler in their famous paper (1999), monop-
olistically competitive firms choose their prices at time t to maximize their
expected discounted profits. They face certain price adjustment constraints
as introduced by Calvo (Galı́ and Gertler, 1999).
In this Calvo setup, each firm has a fixed probability 1 − θ that it may
change its price during the period. When changing its price, a firm takes into
account the expected future path of nominal marginal costs. θ is then the
probability that the price of a firm will remain unadjusted.
The resulting Phillips curve (1.1) is the original benchmark model of
NKPC where inflation πt depends on real marginal cost, or rather on devi-
1
Detailed derivation is available in numerous publications, see for instance Galı́ (2008).
1.1 Hybrid New Keynesian Phillips Curve 11
ation of real marginal cost from its steady state value, mct , and expected
future inflation Et {πt+1 }.
πt = κ mct + βEt {πt+1 } (1.1)

The parameter β represents the firm’s subjective discount factor and κ is
a function of structural parameters κ ≡ (1 − θ)(1 − βθ)/θ.
If we iterated (1.1) forward, it would become obvious that NKPC is a
purely forward looking model. Inflation would be a function of sum of dis-
counted expected real marginal costs. But empirical evidence has suggested
the presence of inflation persistence in data. Therefore, Galı́ and Gertler
(1999) have tried to introduce something in the model that might capture
this inertia of inflation. They allowed a fraction of firms to follow a backward-
looking rule of thumb. This rather ad hoc reformulation of the model divides
the set of firms in two subsets.
The fraction 1 − ω of the firms remain forward looking. These firms still
set their prices optimally with respect to the constraints of Calvo pricing as
described above. The remaining fraction ω of the firms is the part of firms
that follow the backward-looking rule of thumb. When setting prices, these
firms use information about lagged inflation and the average price set in the
most recent round of price adjustments (Galı́ and Gertler, 1999).
The NKPC derived from this setup takes the following form
πt = κ mct + γf Et {πt+1 } + γb πt−1 , (1.2)

where
κ ≡ (1 − ω)(1 − θ)(1 − βθ)φ−1
γf ≡ βθφ−1 (1.3)
γb ≡ ωφ−1
and φ ≡ θ + ω[1 − θ(1 − β)].

This version of Phillips curve is the so-called hybrid NKPC. The term
hybrid refers to the fact that the equation combines the original NKPC (1.1)
and the traditional, so-called accelerationist, version of Phillips curve. Accel-
erationist version is the already mentioned model of Friedman and Phelps
where inflation depends on a real variable (unemployment rate) and adap-
tively formed inflation expectation, i.e. past inflation.
By setting some of the structural parameters from (1.3) equal to certain
values we can obtain special cases of the Phillips curve. If we set ω = 0, that
means if we set all the firms as forward looking, it is logical that we would
get the original (only forward-looking) NKPC (1.1).
12 Single Equation Approach
An interesting case of NKPC can be obtained by setting the discount

factor β = 1. This would mean that the firms would not discount the future
values of variables, i.e. a future profit would have the same importance for
a firm as the current one. This structural parameter restriction then yields
reduced-form parameters restriction γf + γb = 1 and the resulting NKPC has
the following form
πt = κ mct + (1 − δ)Et {πt+1 } + δπt−1 , (1.4)

where δ ∈ (0, 1). This version of NKPC implies long-run verticality of the
curve.
This can be seen if we realize that the real variable is in the gap form. So
in the long run, we assume a zero gap (we are in the steady state so there is
no deviation from it) which leaves us only with past and expected inflation
on the right-hand side of (1.4). Then, the coefficients standing by the two
values of inflation on the right-hand side have to sum up to unity for the
equation to hold true. Mathematically speaking, inflation is then expressed
as the convex combination of its past and expected value.
Further, under the assumption that the desired markup in the absence of
constraints on the frequency of price adjustment is constant, we can derive
a proportionate relation between gap in the real marginal cost and output
gap: mct = ψyt (Galı́, 2008).2 If we plug this relation in equation 1.2, the
resulting hybrid NKPC will look as follows:
πt = λyt + γf Et {πt+1 } + γb πt−1 , (1.5)

where λ = κψ.
This is the version of NKPC that is the subject of our empirical analysis
in following sections and chapter 2.
Let us now look into the econometric form of the hybrid NKPC that is
to be estimated.
1.2 Econometric Hybrid New Keynesian Phil-

lips Curve
Usually, when transforming an equation derived from an underlying economic
theory to its econometric counterpart, we simply add the error term to it. The
reason for this is that our economic theory might not be absolutely correct
2
The output gap in this environment is defined as the deviation of actual output from
the output under flexible prices.
1.2 Econometric Hybrid New Keynesian Phillips Curve 13
and this error term should capture omitted effects of other variables. Here
the situation is a bit more complex.
The equation (1.5) we want to estimate contains the expected inflation
term which is unobserved.3 The presence of this latent variable prevents us
from running a direct regression. In order to be able to estimate (1.5), we
have to circumvent this problem, so to speak. First, we are going to deal with
this issue in a rather formal way (using a very well-written paper by Nason
and Smith (2008)). Then, we will derive the same result in a more intuitive
way. Our approach hinges on the assumption that (1.5) is free of the error
term.4
The expected inflation in (1.5) is a forecast based on all available informa-
tion It . This forecast E[πt+1 |It ] is unobserved. Beside this latent variable, let
us define another forecast, so-called econometric forecast E[πt+1 |zt ]. Here the
prediction is based on some selected variables zt , called instrumental vari-
ables or simply instruments, that are a subset of the available information,
i.e. zt ⊆ It .
To obtain such an econometric forecast, we simply run a regression of
actual future inflation on the instruments: πt+1 = bzt + t+1 . And with some
basic knowledge of econometrics we obtain the econometric forecast as the
fitted value:
E[πt+1 |zt ] = bzt .
Then, by application of the law of iterated expectations,5 we see that our
econometric forecast satisfies the following equation
E[πt+1 |zt ] = E[E(πt+1 |It )|zt ]. (1.6)
And if we regress the unobserved forecast on the instruments: E[πt+1 |It ] =

βzt + ηt , the resulting fitted value is
E[E(πt+1 |It )|zt ] = βzt ,
which by the result from (1.6) yields
E[πt+1 |zt ] = βzt .

3
Using survey data about expected inflation is a very convenient way of estimating
hybrid NKPC directly. Since we do not have such data on expected inflation in the Czech
Republic at our disposal, we have to employ more complicated methods. For estimates of
NKPC using survey data, see for example Roberts (1995).
4
In literature, we can also encounter an approach that begins with NKPC that already
includes the error term. For derivation of the econometric equation that does not contain
latent variables using this stochastic NKPC, see for example Mavroeidis (2004).
5
Law of iterated expectations: E[y] = E[E(y|x)].
This fitted value can be substituted back in the regression equation which
gives a relationship between the unobserved and econometric forecast
E[πt+1 |It ] = E[πt+1 |zt ] + ηt . (1.7)
With this important result in hand, we can now turn our attention to
the hybrid NKPC itself. If we substitute the relationship between forecasts
(1.7) into the NKPC (1.5) and multiply this substituted term in parenthesis
by the reduced-form parameter γf , we obtain an econometric version of the
hybrid NKPC that is already econometrically testable.6
πt = λyt + γf E[πt+1 |zt ] + γb πt−1 + γf ηt (1.8)
This econometric equation of the hybrid NKPC might be identified by

the two-stage least squares (2SLS). It is obvious from (1.8) that the first
stage regression would involve regressing πt+1 on instruments zt . 2SLS is a
special case of a more general estimation technique that we employ in this
thesis. This method is called generalized method of moments (GMM) and
its application to NKPC will be described in detail in next section. But to
be able to apply this method, we have to derive the so-called orthogonality
conditions.
To do this, let us rearrange the hybrid NKPC (1.5), so that all variables
move on the left-hand side of the equation, leaving right-hand side equal to
zero. Then, by taking conditional expected value conditioned by the instru-
ments from both sides, we obtain
E[πt − λyt − γf E[πt+1 |It ] − γb πt−1 |zt ] = 0.
Using the law of iterated expectations and its corollary (1.6) again, we
obtain following equality
E[πt − λyt − γf πt+1 − γb πt−1 |zt ] = 0. (1.9)
Now it is obvious that we have got a typical econometric requirement,

when using instrumental variables, for the conditional mean of the error
term (let us denote it here as εt ) to be zero, that is
E[εt |zt ] = 0. (1.10)

6
To be precise, even this equation is not testable yet, because it contains the output
gap yt which is also unobserved. But this problem is easily solved by using various proxies
for this variable. We want to leave the equation in the most general form as possible at
this point. We will address the question of proxies for yt in more detail later.
1.2 Econometric Hybrid New Keynesian Phillips Curve 15
The conditional mean equal to zero implies (again by the law of iterated
expectation) that also the unconditional mean is zero. With this equality in
mind, we can deduce that relation (1.10) also implies zero covariance between
instruments zt and error term εt , i.e. zt and εt are uncorrelated.
Uncorrelated random variables are said to be orthogonal, if at least one
of the variables satisfies zero-mean condition. Then, we can write C(X, Y ) =
E(XY )+E(X)E(Y ) = E(XY ) = 0 where the last equality is the definition of
orthogonality of random variables. Hence, in our case, relation (1.10) implies
the following orthogonality conditions
E[(πt − λyt − γf πt+1 − γb πt−1 )zt ] = 0 or E[εt zt ] = 0. (1.11)
Other, more intuitive, way how to obtain the orthogonality conditions

required for the GMM estimation proceeds as follows. Subtract and add term
γf πt+1 to (1.5). Then, define ζt+1 ≡ πt+1 − Et πt+1 as the forecasting error.
After rearranging the terms we get
πt = λyt + γf πt+1 + γb πt−1 + υt+1 ,
where υt+1 = −γf ζt+1 .

Then, under the assumption of rational expectations, error of forecast of
πt+1 must be uncorrelated with information dated t and earlier. This follows
from the fact that if people use all available information to forecast inflation,
the forecasting error, which is known only after the realization of πt+1 , will
not have any systematic relation to what people knew when they formed this
expectation (Hayashi, 2000).
Since the forecasting error ζt+1 is indirectly proportional to the error
term of the whole NKPC υt+1 , it is clear that also υt+1 is uncorrelated with
information dated t and earlier. This information is represented by the instru-
ments zt . And by treating uncorrelated variables as orthogonal once again,
we obtain the same orthogonality conditions as before.7
As in the previous derivation, the variable πt+1 is endogenous by construc-
tion and has to be instrumented for. This means that πt+1 is correlated with
the error term υt+1 . This is quite obvious, if we realize that υt+1 = −γf ζt+1 ,
where ζt+1 ≡ πt+1 − Et πt+1 .
With the needed orthogonality conditions (1.11) derived, let us introduce
the identification technique that utilizes these conditions—GMM.
7
The only difference is that in this not as thorough derivation the error term is dated
t + 1 and not t as in (1.11). But this slight discrepancy will not make any difference in the
estimation process.
1.3 Generalized Method of Moments

Before we dive into the description of GMM itself, let us denote the product
from the orthogonality conditions (1.11) as follows: gt = εt zt . Then, we get
the orthogonality conditions in the following form:
E[gt (δ)] = E[gt ] = 0 (1.12)
The first equality in (1.12) is there only to remind us that gt is a function

of the parameter vector δ = (λ, γf , γb )0 . Equation (1.12) can be understood
as a system of so-called moment equations.
Now let us proceed to the generalized method of moments itself. As the
name of the method suggests, this estimation technique is in close relation to
the estimation method of moments. Method of moments is based on setting
equal the population moments and their sample counterparts constituting a
system of, let’s say K, moment equations.8 To obtain moment equations in
form with 0 on the right-hand side of the equation as in (1.12), we simply
rearrange the original moment equations. In our case the method of moments
procedure suggests that if the population moments (1.12) are equal to zero,
their sample counterparts should be equal to zero as well. If K = L, the
estimation can be carried out by solving the system of L equations in L
unknowns.
But the number of moment equations does not always have to be equal
to the number of parameters L we want to estimate. If K < L, that is if
we have more parameters than moment equations, the model is said to be
underidentified. In this situation we do not have enough information (moment
equations) to find solution to the equation system.
If K = L, the procedure described above can be applied. The obtained
vector of parameter estimates will be a unique solution to the system of
moment equations. The model is then called exactly identified.
If K > L, that is if the number of moment equations exceeds the number
of parameters, there is no unique solution to the system of equations. In this
case the model is called overidentified.9 We then have to come up with some
criterion that would help us to choose the vector of parameter estimates. So
if we can not set the sample moments equal to zero, we will try to find a
vector of parameters δ̂, so that the sample moments come as close to zero as
8
The reasoning behind this approach and detailed description can be found for example
in Greene (2003).
9
Note that K is not only the number of orthogonality conditions but also the number
of instruments we use. Similarly L is not only the number of parameters to be estimated
but logically also the number of regressors in our model.
1.3 Generalized Method of Moments 17
possible. This is basically the general idea behind the generalized method of
moments.
To measure the distance from zero we wish to minimize, we define a
quadratic form (ξ − η)0 Ŵ (ξ − η), as a measure of distance between any two
K-dimensional vectors ξ and η, where Ŵ is a symmetric positive definite
weighting matrix.
The vector difference is already built in in our moment equations (1.11)
or (1.12). To see this, let us denote our NKPC model in a more general form:
yt = xt 0 δ + εt ,
where yt = πt and xt is the L dimensional column vector of regressors.10

Then, the orthogonality conditions (1.11) (or moment equations (1.12))
can be rewritten as
E[zt εt ] = E[zt (yt − xt 0 δ)] = E[zt yt ] − E[zt xt 0 ]δ = σZY − ΣZX δ = 0.
Now, let us define the sample counterparts of these moments that will
enter our minimization criterion:
n n n
1X 1X 1X
gn = zt (yt − xt 0 δ̃) = zt yt − ( zt xt 0 )δ̃ = sZY − SZX δ̃,
n t=1 n t=1 n t=1
where n is the sample size.

Therefore, gn is a difference between two vectors and this difference
should be as small as possible. Realizing this, we can write our GMM es-
timator δ̂ as the vector of parameters that minimizes the distance measured
by a quadratic form. Hence
δ̂(Ŵ ) ≡ argmin J(δ̃, Ŵ ), (1.13)

δ̃
where
J(δ̃, Ŵ ) ≡ n · gn (δ̃)0 Ŵ gn (δ̃).
Note that the quadratic form is multiplied by the sample size n. The
reason for this is that this multiplication enables us to test the so-called
overidentifying restrictions. This topic will be discussed in more detail later.
Since our model is linear, this minimization problem is analytically solv-
able in a quite straightforward way by taking derivative of J with respect to
10
Here we focus only on estimation of our linear model. But GMM is a very general
method and can be employed to estimate even nonlinear models using numerical minimiza-
tion of the criterion. For more information on GMM, see e.g. Greene (2003) or Hayashi
(2000).
δ̃, setting it equal to zero and solving for δ̃. The resulting GMM estimator
is then:
δ̂(Ŵ ) = (SZX 0 Ŵ SZX )−1 SZX 0 Ŵ sZY (1.14)
It is important to note that GMM is applicable if K ≥ L (so-called order

condition for identification). If K = L, then, the resulting estimator (1.14)
becomes a simple instrumental variables estimator δ̂ = SZX 0−1 sZY .
Now, let us look at some asymptotic properties of this GMM estimator.
To derive those, we assume only ergodic stationarity of the used data and
that gt is a martingale difference sequence with finite second moments.
Stationarity of a process means that the process retains its properties in
any point of time. In case of strong stationarity this means that the distribu-
tion of a process remains unchanged. If the process is weakly stationary, its
expected value and autocovariance do not depend on the point of time when
they are calculated.
An ergodic process is asymptotically independent. That is, if any two
random variables are positioned far apart in the sequence, they are almost
independently distributed (Hayashi, 2000).
A martingale difference sequence is a vector process whose conditional
expected value conditioned by its past values is zero. This implies (by the
law of iterated expectations) that also the unconditional expected value is
zero. A martingale difference sequence also contains the property of no serial
correlation.11
A fact that is quite important to realize is that we do not need εt to
be normally distributed. We circumvent this requirement by utilizing the
asymptotic properties.
First asymptotic property of the GMM estimator is that it is consistent,
i.e. plimn→∞ δ̂(Ŵ ) = δ.
Second asymptotic property—asymptotic normality—will be discussed
under the case of the efficient GMM estimator. First reason is that efficient
estimator—one that has the least asymptotic variance—is the one that is
of particular interest to us and second reason is that asymptotic variance
matrix of efficient GMM estimator is much simpler than the one of general
GMM estimator.
The efficiency is achieved through the right choice of the weighting matrix
Ŵ . The right choice turns out to be
W (≡ plimŴ ) = S −1 (1.15)
11
For formal definitions of these rather technical terms, see again Greene (2003) or
Hayashi (2000).
1.3 Generalized Method of Moments 19
where S = E[gt gt 0 ] = E[ε2t zt zt 0 ] and the matrix S can be consistently esti-

mated as n
1X 2
Ŝ ≡ ε̂ zt zt 0 . (1.16)
n t=1 t
Then, the efficient GMM estimator can be written as
δ̂(Ŝ −1 ) = (SZX 0 Ŝ −1 SZX )−1 SZX 0 Ŝ −1 sZY (1.17)
and has following property
√
n[δ̂(Ŝ −1 ) − δ] → N (0, Avar(δ̂(Ŝ −1 ))) as n → ∞. (1.18)
d
where
Avar(δ̂(Ŝ −1 )) = (ΣZX 0 S −1 ΣZX )−1 (1.19)
Before we get lost in the amount of equations, let us summarize the GMM
procedure as in Hayashi (2000). GMM is a two-step estimation procedure.
In the first step, we have to choose some matrix Ŵ . This is usually
done in two ways. First possibility is to set Ŵ = I, where I is the identity
matrix. Second possibility might be setting Ŵ = SZZ −1 which is the more
usual variant. This choice would lead to the already mentioned two-stage
least squares estimation (2SLS) in the first step.12 Then, with Ŵ in hand,
we can minimize J(δ̃, Ŵ ) to obtain first-step estimates δ̂(I) or δ̂(SZZ −1 ).
With the first-step estimates we can now calculate the residuals ε̂t ≡
yt − xt 0 δ̂(Ŵ ). These residuals enable us to compute the consistent estimate
Ŝ (see (1.16)) of S.
Now we have a consistent estimate of the optimal weighting matrix Ŝ −1
at our disposal and we can minimize J(δ̃, Ŝ −1 ) to obtain the efficient GMM
estimator δ̂(Ŝ −1 ). This repeated minimization and acquiring the efficient
GMM estimator as the minimizer is the second step of the GMM procedure.
So far we have assumed that gt is a martingale difference sequence which
features, besides other properties, also no autocorrelation. But here we are
dealing with a time-series model and the econometric equation containing
only three regressors might not be rich enough to capture all the inflation
determinants. Therefore, it is highly probable that our model will suffer from
so-called dynamic misspecification whose symptom is the serial correlation.
To obtain consistent estimates even in this situation we have to somehow
modify the matrix S. Therefore, we define a long run covariance matrix that
reflects the autocorrelation property of gt :
∞
X ∞
X
S= Γj = Γ0 + (Γj + Γj 0 ), (1.20)
j=−∞ j=1
12
Proving this is straightforward and it can be found in Hayashi (2000).
where Γj is the j-th order autocovariance matrix
Γj = E(gt gt−j 0 ) (j = 0, ±1, ±2, ...).
It is obvious that our previous matrix S containing no serial correlation

is simply Γ0 .
Now we have to find a way how to consistently estimate (1.20). We start
with consistent estimation of the autocovariance matrix
n
1 X
Γ̂j = ĝt ĝt−j 0 (j = 0, 1, ..., n − 1), (1.21)
n t=j+1
where
ĝt ≡ zt · ε̂t , ε̂t = yt − xt 0 δ̂, and δ̂ is a consistent estimate of δ.
With consistent estimate (1.21) in hand, we can proceed to the consis-

tent estimation of S. We will use the so-called kernel-based approach. This
approach estimates S as a weighted average of autocovariances estimated by
(1.21). Hence, the estimate is
n−1
X j
Ŝ = k · Γ̂j . (1.22)
j=−n+1
q(n)
The function k(.) determines the weights assigned to particular autoco-

variances. This function is called the kernel. Another function in the expres-
sion (1.22), q(n), determines the number of terms that are to be averaged
and is called the bandwidth. Bandwidth usually depends on the sample size
n.
Although there are several possible kernels which an econometrician might
use, we will only present the Bartlett kernel we used in the estimation process
of NKPC. This type of weighted averaging has the following form:
(
1 − |x| for |x| ≤ 1
k(x) =
0 for |x| > 1
Regarding the choice of bandwidth, quite a frequent option is nw1 =

0.75n1/3 . An alternative to this might be the following bandwidth: nw2 =
4(n/100)2/9 .13
13
The first one is a default bandwidth utilized by the software Gretl that we used to
estimate NKPC. The alternative bandwidth nw2 is the default bandwidth applied by
another popular econometric software, EViews.
1.4 Estimation Results 21
If we compute an estimate of the asymptotic variance matrix (1.19) using

(1.22) instead of (1.16), the asymptotic variance matrix is said to be hete-
roskedasticity-and-autocorrelation-consistent (HAC). The efficient GMM es-
timator calculated using (1.22) instead of (1.16) with the consequent HAC
asymptotic variance retains its properties, i.e. it remains consistent and
asymptotically normal.
To conclude this theoretical section, let us point out some potential issues
relating to GMM estimation. Although it has some appealing properties like
consistency, asymptotic normality, while it does not require normality of the
error term, it might have some serious flaws as well.
As already mentioned, the nice properties of the GMM estimator are
large-sample properties. But if we have only small sample, there might arise
some serious problems. In particular, when using the efficient GMM estimator
that utilizes Ŝ −1 , a function of estimated fourth moments, the estimate of
Ŝ −1 might not be too reliable (Hayashi, 2000). According to Hayashi (2000),
using Ŵ = I can outperform the efficient GMM estimator in terms of the
bias and variance in finite samples. Of course there is no clear-cut line of
what is still a small sample and what is already a large sample.
Another drawback of GMM is that the results are often sensitive to the
specification of the orthogonality conditions (1.11). If we substituted the
structural parameters back in and estimated them instead of the reduced-
form parameters, the results might depend on normalization of πt in (1.11).
That is, the results would probably depend on whether φ stays in the de-
nominator or whole equation is multiplied by it to get in the numerator (see
(1.3)). Therefore, we estimate only the reduced-form parameters from (1.5)
in this thesis. Some other issues of the GMM estimation will be addressed in
the following practical section.
With GMM theory explained let us proceed to the estimation procedure
in practice and presentation of the identification results.
1.4 Estimation Results

In the theoretical section concerning the derivation of NKPC we discussed
how the inflation is determined. But we did not mention what kind of in-
flation should follow the NKPC relationship. In practice, we can measure
inflation in several ways. A natural measure in our NKPC model would be
quarter-over-quarter (q-o-q) inflation. In this thesis, we also study how an-
other very common measure of inflation—year-over-year (y-o-y)—performs
in our NKPC model.
Since consumer price index (CPI) and implicit price deflator (IPD) are
relatively evenly utilized in literature, we use both of these measures and

study the differences between them. Hence, we estimate NKPC using q-o-q
inflation measured as the change in the log of CPI, q-o-q inflation measured
as the change in the log of IPD, y-o-y inflation measured as the change in
the log of CPI and finally y-o-y inflation measured as the change in the log
of IPD.
All data are seasonally adjusted quarterly data of the Czech economy.
The source of the data are Czech Statistical Office, Czech National Bank
and Ministry of Labour and Social Affairs. The range of the data is 1996:Q1–
2009:Q3. But since we use the future inflation and four lags of variables as
instruments, our data set spans effectively from 1997:Q1 to 2009:Q2.
This means that we have only 50 observations at our disposal. This rather
shorter data range is probably the biggest drawback of the estimation ap-
proach used in this chapter. Since we rely on asymptotic properties, 50 ob-
servations might not seem enough. But even with this sample we were able to
acquire some interesting results. Before we present them, we should discuss
how we have resolved the problem of the endogenous variable πt+1 in 1.11
and what proxy we used for yt .
1.4.1 Instrumental and Proxy Variables

Let us start with the problem of the proxy variables. As we have seen, both
NKPC equations (1.2) and (1.5) featured unobserved variables. In (1.2) it is
the marginal cost, in (1.5) the gap between actual output and output under
flexible prices that is unmeasured. In order to be able to estimate either of
these two equations, we have to find suitable proxies for these unobserved
variables.
Galı́ and Gertler (1999) estimated both of these equations using real unit
labor cost as a proxy for marginal cost and quadratically detrended log of
real gross domestic product (GDP) as a measure of output gap.14
According to their results, the gap in real unit labor cost proved to be a
better proxy for the driving variable. But other researchers came with results
demonstrating that also various measures of the output gap can provide
reasonable results (see e.g. D’Amato and Garegnani (2008)). Overall, to our
knowledge, using some kind of measure of the output gap is probably the
more often used approach when dealing with proxy for the real variable.15
14
To be precise, they estimated the original only forward-looking NKPC this way.
15
Sometimes in literature, one can find a measure of the output gap being understood
as a proxy for marginal cost instead of for the unmeasured output gap (see D’Amato and
Garegnani (2008)). In our opinion, this is not the most precise procedure considering the
theory covered in section 1.1. But as long as only the reduced-form parameters of NKPC
In this thesis we estimate only (1.5), simply because we do not have

the data required to construct the gap in real unit labor cost. Our proxy
for the output gap is calculated by using the Hodrick-Prescott filter with a
smoothing parameter 1600 on GDP time series.16
Besides the problem of unmeasured driving variable, we have to solve
the problem of endogeneity of πt+1 .17 As already mentioned in section 1.2,
the endogenous variable πt+1 has to be instrumented for. What we mean by
instrumenting for is that we want to find some other variables—instrumental
variables or instruments—that are correlated with πt+1 but not with the error
term. Then, we run the so-called first-stage regression where we regress the
endogenous variable πt+1 on the instruments. Then, we use the fitted values
from this regression in our NKPC equation.
The two before mentioned properties, that instruments should have, can
make finding the right instruments quite a difficult task.18 In most papers,
econometricians resolve this problem by using lagged macroeconomic vari-
ables. The rationale for this is that past values of these variables should be
exogenous and, therefore, uncorrelated with a shock to the current inflation,
i.e. with the error term εt from our orthogonality conditions (1.11) (Nason
and Smith, 2008).
To check if our estimation results are robust to various instrument sets, we
utilize five different sets of instruments. The choice of the following macroe-
conomic variables was based on the instruments most commonly used in
literature.
First instrument set Z1 contains four lags of the following variables: in-
flation (π), output gap (y) and two-week REPO interest rate at the end of
each quarter (r).
Second instrument set Z2 contains four lags of all of the variables from Z1
and also four lags of HP-filtered gap of real unit wage costs (s) and energy
inflation (πE ).
Third instrument set Z3 contains four lags of: π, y, r, πE , first difference of
the logarithm of real exchange rate CZK/EUR (∆rER) and unemployment
rate (U R).
Fourth instrument set Z4 contains four lags of: π, r, ∆rER and U R.
Last instrument set Z5 is the same as Z4 , only four lags of y are added.
and not the structural ones are estimated, it makes no difference.

16
We also used the quadratically detrended log GDP and the estimation results were
very similar.
17
Endogeneity means that the variable is correlated with the error term—in our case by
construction. See section 1.2.
18
Note that we have to find at least three instruments, that have the desired properties,
in order to satisfy the order condition of identification, i.e. K ≥ L.
In addition, all instrument sets contain a constant (since it is surely un-

correlated with the error term εt ) and also the current value of the output
gap, yt .
The reason for including yt is that we carried out the Hausman endogene-
ity test for every data specification and every instrument set and found out
that yt was an exogenous variable in all of the specifications.19
Theoretically, excluding the current output gap from instrument sets (as
would the potential measurement-error bias suggest) would result in losing
some information that can be exploited. In other words, there would be less
orthogonality conditions to utilize.20
Excluding the output gap would mean that we would have to instrument
for it as well. Based on the results of the Hausman endogeneity test, we
instrument only for πt+1 as did e.g. Menyhért (2007). Now, let us look at the
estimation results for the four different measures of inflation.
1.4.2 Empirical Results

First we estimated NKPC using the q-o-q CPI measure of inflation. We used
the two-step GMM with HAC standard errors, as described in section 1.3.
The initial matrix was Ŵ = SZZ −1 , hence, in the first step we calculated
2SLS. One detail has to be pointed out though. We do not utilize any of
the bandwidths nw1, nw2 depending on the sample size. Instead we use a
bandwidth 12 as suggested by Galı́ and Gertler (1999).
The reason for this is that the from sample size calculated bandwidth
nw1 or nw2 would result in too small an autocorrelation horizon. This could
lead to some serious bias of the estimates, because the autocorrelation is a
persistent problem in the Czech data, as we will see later.
The estimation was conducted using the open-source software package
Gretl. The results from estimating the q-o-q CPI inflation are summarized
in Table 1.1.
First thing that has to be checked before we start analyzing the parameter
estimates is whether our orthogonality conditions have been met. This is
checked by looking at J-test values in Table 1.1. These values are the p-
values of the test that the J statistic—our quadratic form multiplied by the
sample size—is smaller than a critical value from the χ2 distribution with
K − L degrees of freedom. The multiplication by the sample size causes that
the J statistic follows χ2 (K − L).21
19
For a simple explication of the Hausman endogeneity test, see e.g. Verbeek (2004).
20
In fact, there were no big differences in the estimates when we left out the current
output gap. To be precise, the underlying conclusions were the same.
21
For detailed derivation, see Hayashi (2000).
Table 1.1: GMM estimation using q-o-q CPI inflation
λ γf γb Wald SCH J-test IV

Z1 0.005 0.581*** 0.148*** 0.000 6 0.962 4.34
(0.021) (0.049) (0.040) (0.729)
Z2 0.009 0.547*** 0.167*** 0.000 6 0.999 2.63
(0.012) (0.039) (0.026) (0.714)
Z3 0.009 0.524*** 0.184*** 0.000 6 1.000 3.31
(0.013) (0.027) (0.014) (0.708)
Z4 0.005 0.554*** 0.166*** 0.000 6 0.996 3.42
(0.019) (0.038) (0.020) (0.721)
Z5 0.017 0.439*** 0.241*** 0.000 6 0.999 3.67
(0.013) (0.028) (0.019) (0.680)
Notes: * denotes 10% significance, ** denotes 5% significance, *** denotes 1%

significance. A ? sign by the Wald test p-value is appended, if the F-test gives
contravening result at 5% significance level.
We see from Table 1.1 that p-values from the J-test are much higher
than any significance level usually applied. Therefore, we can say that our
orthogonality conditions have been met and NKPC fit the data (Nason and
Smith, 2008). How well it fits can be analyzed from the rest of the data in
Table 1.1.
We have obtained significant estimates of the inflation parameters γf
and γb with forward-looking parameter playing the dominant part. On the
other hand, estimates of the parameter λ are statistically insignificant in all
cases. Despite the insignificance, we have reached the correct sign of the real
variable parameter.
We can also see that our parameter estimates are not too robust when
using different instrument sets. This suggests weak identification. Weak iden-
tification means that, although our instruments meet the first requirement—
uncorrelatedness with the error term (suggested by the J-test)—they do not
meet the second requirement. They simply are not correlated with our en-
dogenous variable πt+1 enough, i.e. our instruments are weak.
But we should not be too surprised by this result. If we realize that we
are trying to explain future inflation by past values of some macroeconomic
variables, it is clear that the instruments simply will not have such explain-
ing power. Therefore, by using past macroeconomic variables we are able to
ensure the exogoneity of instruments, but we struggle to fit our endogenous
variable well enough. Weak identification is a common problem in literature,
as well, when estimating NKPC.
Although there is no exact and in all cases usable method of checking
weak instruments (especially in situation where our model contains a forward-
looking term, Mavroeidis (2004)), the last column of Table 1.1 might shed
some light on this problem. This column contains values of the ordinary
F statistic (of the hypothesis that all slopes are zero) from the first-stage
regression, where we instrumented our endogenous variable πt+1 .
If our instruments are strong, the F statistic should be high. The problem
is, we do not know how high. It differs from regression to regression. There
is a very simplifying rule of thumb that says that if our F statistic is bigger
than 10, our instruments are strong and vice versa (Adkins, 2009). But as
we already mentioned, this is no exact statistical test.
The values of F statistic in Table 1.1 suggest that our model is proba-
bly weakly identified. In any case, our estimates of γf range from 0.439 to
0.581 and γb from 0.148 to 0.241 which is not such a wide range. Despite
these relatively robust estimates, we will try to remove the problem of weak
instruments in one of the following subsections by employing a method that
should be robust to weak instruments.
Another problem that is apparent from the Table 1.1 is the presence of
serial correlation. The column denoted as SCH contains the serial correlation
horizon (SCH). We tested the autocorrelation using the Breusch-Godfrey
test, but we tested it only up to 6 periods.22 So if the value is 6, the actual
order of serial correlation might be even higher. The point is that our model
shows signs of omitted dynamics in all five cases.
Although we are still able to obtain consistent estimates using the HAC
standard errors, the presence of serial correlation suggests that we have omit-
ted something in our regression. A logical remedy for this problem would be
adding more inflation inertia in the NKPC. This approach is explained, ap-
plied and discussed in the following subsection.
Last column we have not mentioned yet contains the answer to one of
our questions from the Introduction section. Via the Wald test, that enables
us to test linear restrictions on parameters, we are able to test the long-run
verticality of NKPC as described in section 1.1. The Wald column contains
the p-values of the asymptotic test that γf + γb = 1 and the actual value
22
Again, see Hayashi (2000) or Greene (2003) for detailed explication of how the Breusch-
Godfrey test is constructed.
γ̂f + γ̂b in parenthesis, respectively.23

We see that all the p-values of the asymptotic Wald test are zero sug-
gesting rejection of the long-run verticality hypothesis. And in this case, it is
no wonder, if we look at the actual sum values in parentheses ranging from
0.680 to 0.729.
But this asymptotic version of the Wald test can sometimes offer some
misleading conclusions when using relatively small sample. As we will see
later, this asymptotic test rejects the hypothesis of the long-run verticality far
too often when using small sample. Therefore, we also calculated an ordinary
F-test testing the same hypothesis.
The problem of this approach is that F-test requires normality of the error
term. But that is a property that we have not required in our theoretical
section. Hence, our F-test results have a rather approximative character and
are not reported explicitly. On the other hand, in a relatively small sample
the F-test might lead to a smaller bias than using an asymptotic test with
50 observations.
If the “harsher” asymptotic test contravenes the results from the F-test,
a ? sign is appended to the p-value suggesting that the F-test offers different
answer. But as can be seen from the Table 1.1, when inflation is measured
as the q-o-q using CPI, both tests reject the hypothesis of the verticality of
NKPC in the long run.
Let us see how the results change when we use IPD instead of CPI. The
results are reported in Table 1.2.
Again, we first have to check if our orthogonality conditions hold true.
Similar high p-values as before suggest that also in this case our model has
passed the overidentifying restrictions test.
An important difference in comparison with the q-o-q CPI inflation are
the parameter estimates. This time we were able to obtain significant esti-
mates of all the parameters. But the parameter λ of our real variable—output
gap—has an opposite sign this time. This negative sign, of course, contra-
dicts the economic theory. We would expect that an increase in the output
gap should lead to an increase in inflation.
Beside this important difference, there are some other notable changes.
First of all, the estimates of γf are much higher than before, ranging from
0.797 to 0.821. In effect, we can not rule out the verticality hypothesis of
NKPC in the long run (see Wald column of Table 1.2).
23
In literature, NKPC is sometimes estimated only as the restricted model with the
restriction γf + γb = 1 imposed. See for example Menyhért (2007) for this approach. In
this thesis we estimate the general NKPC and rather test the long-run verticality instead
of imposing it.
Table 1.2: GMM estimation using q-o-q IPD inflation

Z1 -0.080*** 0.821*** 0.198*** 0.245 6 0.978 2.51
(0.024) (0.050) (0.044) (1.020)
Z2 -0.076*** 0.797*** 0.209*** 0.571 6 0.999 1.66
(0.020) (0.030) (0.028) (1.006)
Z3 -0.077*** 0.810*** 0.202*** 0.194 6 1.000 1.17
(0.019) (0.024) (0.023) (1.012)
Z4 -0.078*** 0.805*** 0.204*** 0.426 6 0.996 2.15
(0.021) (0.036) (0.038) (1.010)
Z5 -0.079*** 0.810*** 0.203*** 0.208 6 0.999 1.53
(0.020) (0.032) (0.032) (1.014)

Although relatively low values of the F statistic reported in last column

of Table 1.2 suggest weak identification, our results are quite robust across
various instrument sets this time. The forward-looking term is the dominant
one, accounting for ca. 80% of the joint effect of expected and past inflation
on current inflation.
Despite seemingly improved estimation results our model still suffers from
serial correlation of high order. Again, we try to deal with this problem in
next subsection.
Now, let us see what results we obtain, if we use year-over-year measures of
inflation instead of quarter-over-quarter. As we know, y-o-y inflation should
not exhibit such high volatility as the q-o-q inflation. The q-o-q inflation is
much more likely to capture every single shock or oscilation. How the results
change, when we use less volatile y-o-y inflation, capture the two following
tables.
The first one reports the results obtained when estimating the y-o-y in-
flation measured via CPI.
Again, J-test p-values show that our orthogonality conditions are valid
and therefore, our model meets the main requirement for good estimation.
Table 1.3: GMM estimation using y-o-y CPI inflation

Z1 0.015 0.512*** 0.502*** 0.035? 6 0.962 20.78
(0.016) (0.015) (0.015) (1.014)
Z2 0.013 0.518*** 0.497*** 0.008? 6 0.999 18.43
(0.011) (0.013) (0.012) (1.015)
Z3 0.010 0.528*** 0.489*** 0.002? 6 1.000 22.29
(0.011) (0.012) (0.011) (1.017)
Z4 0.011 0.518*** 0.497*** 0.012? 6 0.996 15.71
(0.016) (0.013) (0.013) (1.016)
Z5 0.016 0.510*** 0.503*** 0.020? 6 0.999 14.25
(0.013) (0.012) (0.012) (1.014)

As before when we had used q-o-q CPI, we have obtained estimates of

the parameter λ with a positive sign. However, as before, we can not rule
out the null hypothesis that the parameter is zero, i.e. that λ is statistically
insignificant.
Whereas in the q-o-q CPI model the forward-looking term played the
dominant role, here the forward-looking and backward-looking terms have
almost equal weights. The forward-looking one, γf , is just slightly the more
important one again.
As is quite apparent from the Table 1.3, our estimates are robust to
different instrument sets. This is also confirmed by the power of instruments.
In all cases the F statistic from the last column of Table 1.3 is clearly above
10.
When testing the long-run verticality of NKPC, we have encountered
the contradicting results of the asymptotic Wald test and the F-test for the
first time. We see that we have obtained similar sum of parameter estimates
(figures in parentheses in the Wald column) as in the Table 1.2, but this time
the asymptotic Wald test rejected the null hypothesis of long-run verticality
in all cases. Although the p-values are pretty close to conventional significance
level α = 0.05, they are still not high enough.

The ? signs appended to all of the p-values show that the traditional F-
test could not reject the hypothesis of γf + γb = 1. And if we consider what
the hypothesis is in this case and how rejecting null hypothesis in statistics
works, we simply have to doubt the results of the asymptotic Wald test in
this case.
When testing a null hypothesis, we have to be 95% (when using α = 0.05)
sure to be able to reject the hypothesis. On the other hand, not rejecting
the hypothesis does not automatically mean accepting it. Informally put, it
means that we do not know. But here the asymptotic Wald test says that it
is 95% sure that sums of parameter estimates ranging from 1.014 to 1.017 do
definitely not suggest that γf + γb = 1. Whereas when using more volatile
q-o-q data, it could not rule out the same hypothesis with similar sums of
parameter estimates.
Therefore, we rather go with the traditional F-test in this case. Its results
follow more our intuition, if we consider how the hypothesis testing works.
Values in SCH column suggest high order of serial correlation, again.
Although the individual p-values (not reported in the tables) of Breusch-
Godfrey test for different orders of autocorrelation were much higher than in
previous cases, they did not reach or exceed the significance level α = 0.05.
Hence, we have to conclude that also using y-o-y CPI inflation produces a
model suffering from serial correlation.
How the model of NKPC performs on y-o-y inflation measured via IPD
shows Table 1.4.
The results are similar to some extent to the results from the previous
IPD estimation in Table 1.2. Results of the J-test allow us to continue with
our identification analysis. Again, all our parameter estimates are statisti-
cally significant. The estimates of λ are negative again and very similar in
magnitude to those from Table 1.2.
What changed are the weights of backward- and forward-looking param-
eters. Although the forward-looking parameter is still the dominant one, its
dominance is not as substantial as before. It ranges from 0.603 to 0.615. This
very narrow range suggests again that also in this case our instruments are
strong enough. This conclusion is also supported by the values in the last IV
column reporting the F statistics from the first-stage regression.
When testing the long-run verticality of NKPC, we face the same problem
as before, i.e. contradicting results from the asymptotic Wald test and the F-
test. Although the sums of parameter estimates are somewhat higher, values
of 1.05 would still suggest that we are close enough to 1. Following the same
logic as in the previous case, we go with the conclusion based on the results
of the F-test. Hence, we do not rule out the long-run verticality.
Table 1.4: GMM estimation using y-o-y IPD inflation

Z1 -0.063*** 0.606*** 0.445*** 0.000? 6 0.962 14.70
(0.016) (0.014) (0.013) (1.051)
Z2 -0.063*** 0.603*** 0.447*** 0.000? 6 0.999 12.58
(0.013) (0.011) (0.010) (1.051)
Z3 -0.062*** 0.605*** 0.446*** 0.000? 6 1.000 7.83
(0.011) (0.010) (0.010) (1.051)
Z4 -0.066*** 0.615*** 0.438*** 0.000? 6 0.996 12.73
(0.017) (0.013) (0.012) (1.053)
Z5 -0.064*** 0.609*** 0.442*** 0.000? 6 0.999 9.82
(0.013) (0.011) (0.011) (1.052)

Once again, our model suffers from serious autocorrelation. But before we
present and apply potential rectification of this problem of omitted dynamics
in NKPC, let us briefly summarize our results we have acquired so far.
When using q-o-q measured inflation, our estimation probably suffers
from weak identification. This can be seen in rather wide ranges of our pa-
rameter estimates. Nevertheless, we are able to say that the forward-looking
term in NKPC play the dominant role in both cases.
If we compare particular q-o-q measures of inflation, one particular differ-
ence is the most striking. When using q-o-q CPI inflation, our real variable
parameter estimates have positive signs, though they are not statistically sig-
nificant. On the other hand, when using q-o-q IPD, all parameters are higly
significant and λ has negative sign.
Similar results concerning the parameter λ are obtained when using y-
o-y inflation measures. In these two cases, the forward-looking term is the
dominant one again, although its dominance is not as striking as in the two
q-o-q cases.
The biggest difference between q-o-q and y-o-y inflation measures is the
instruments’ power. In q-o-q inflation cases our models are weakly identified.
Whereas y-o-y inflation measure models demonstrate strong identification

resulting in robust estimates. This means that we are able to obtain reason-
able and convincing estimation results when using less volatile measures of
inflation.
Testing the long-run verticality of NKPC offers also interesting results.
Only in the first data specification—q-o-q CPI inflation—the null hypothesis
of long-run verticality could be rejected with absolute certainty. When ap-
plying other data specifications, we could not reject NKPC verticality in the
long run.
Overall, we can say that NKPC fitted the Czech data using q-o-q CPI
inflation the worst from the four data specifications. However, using other
inflation measures gave reasonable results.
It is interesting that our results are quite similar to those of Galı́ and
Gertler (1999) who tested NKPC on American data. They, too, found the
forward-looking term to be the predominant one and a measure of the output
gap not being the ideal proxy variable for the driving variable when using
GMM.
But the predominance of the forward-looking term might be caused by
the use of lagged inflation in the instrument sets, as it can “steal” some of
the influence of the lagged inflation that is represented in NKPC by infla-
tion lagged only by one period. Including more inflation inertia in NKPC is
discussed in next subsection in the context of omitted dynamics, but it can
answer also the question of potential “biased” too dominant estimates of the
forward-looking parameter.
What was a common problem in all of the data specifications was the
serial correlation that Galı́ and Gertler (1999) did not even test for. This
issue is the subject of the following subsection.
1.4.3 Problem of Omitted Dynamics

In the previous subsection we have found strong evidence of serial correlation
in all of the data specifications of our model. In this subsection we try to kill
two birds with one stone.
By adding stronger inflation persistence in our model, we try to rectify the
problem of serial correlation. Furthermore, by adding more lags of inflation
in NKPC itself (and not only in the instrument sets), we want to find out
whether our estimates of the forward-looking term are biased upwards due
to the inflation lags in the instrument sets.
Before we proceed to this model modification, let us briefly explain the
logic of adding more lags of inflation in the NKPC model. Although we were
able to obtain consistent estimates via the GMM procedure by using the
HAC asymptotic variance matrix, serial correlation indicates some sort of

model misspecification. This means that our estimation procedure is not the
problem, the model itself is. Therefore, we want to modify it a bit.
What we mean by misspecification is that either our model lacks some
variables or simply the process of dependent variable is more persistent than
our model allows for. Since trying to find out what other variables might
be included in the model would be a rather trial-and-error guessing, we will
assume that inflation is more persistent process and will focus on this issue.
In section 1.1 we already mentioned that modifying the original NKPC
into the hybrid one was a rather ad hoc process. Yet, it can be derived from
the microeconomic foundations by letting a fraction of the firms follow a
backward-looking rule of thumb. The modification we are going to apply in
this section does not have support in the microeconomic foundations. This is
a purely ad hoc econometric alteration of the model that is trying to rectify
an econometric problem.
Using a very simple illustrative example from Wooldridge (2000), let us
shortly explain why adding lagged dependent variable to a model might in
some cases result in getting rid of autocorrelation.
Consider following model:
xt = β0 + β1 xt−1 + ut ,
where ut is AR(1) process, i.e. ut = ρut−1 + et . The error term et is a series

of independent and identically-distributed (i.i.d.) random variables.
Then, if we lag our model one period and rearrange it, we can obtain
following expression:
ut−1 = xt−1 − β0 + β1 xt−2 .
This can be substituted in the AR(1) process of our error term ut to

obtain
ut = ρ(xt−1 − β0 + β1 xt−2 ) + et .
And finally, if we substitute this expression into our original model, we
get following alteration of the model:
xt = β0 (1 − ρ) + (β1 + ρ)xt−1 − ρβ1 xt−2 + et

xt = α0 + α1 xt−1 − α2 xt−2 + et
The error term in this new model is already an i.i.d. random variable.
We see that by allowing for deeper persistence of the dependent variable of
the model, we were able to get rid of the serial correlation. But it is clear
that this procedure was based on the fact that we knew that the original
error term followed AR(1) process. In practice however, this might be quite
difficult to determine.
During the estimation process we used the Breusch-Godfrey test to detect
serial correlation. But the Breusch-Godfrey technique tests the validity of a
hypothesis that there is no autocorrelation against the alternative that error
term follows AR(p)/MA(p) process. Hence, we do not know exactly what
kind of process the error term from our NKPC model exactly is. And even
if we knew, we would be able to deal only with AR processes.
Other reason, why we modify our NKPC model this way, was already
mentioned. We want the inflation inertia has its own representation in the
NKPC itself. Since the tests confirm the presence of serial correlation, it
might be a reasonable guess that deeper inflation persistence should be in-
corporated in the model. Because otherwise the parameter estimates cor-
responding to the forward-looking term might be biased upwards. This is
because we use four lags of inflation in the instrument sets to instrument for
our forward-looking endogenous variable πt+1 .
Therefore, also four lags of inflation enter the NKPC itself, now. Using
quarterly data, this means that we add another three quarters of inflation
persistence to the model, as did Galı́ and Gertler (1999) and other authors,
to obtain
πt = λyt + γf πt+1 + γb1 πt−1 + γb2 πt−2 + γb3 πt−3 + γb4 πt−4 + υt+1 .
Again, we estimate this equation in the same manner as before using all
four different inflation measures. HAC standard deviations are not reported
in tables in this subsection to keep the size of the them at a reasonable level.
First table from this subsection, Table 1.5, reports the estimation results of
our modified model using q-o-q CPI inflation.
Our model passes the overidentifying restrictions test in all cases, as the
figures in J-test row indicate.
Before we comment on interesting changes in parameter estimates, let us
point out that this model alteration has not resolved the problem of model
misspecification. SCH row, containing the figures of maximum serial correla-
tion horizon tested, shows that autocorrelation is still present in the model.
We have not even managed to weaken this property.
This shows that the model suffers from some more serious misspecifi-
cation. It probably needs adding some other variables. But, as mentioned
before, even when facing autocorrelation we are able to obtain consistent
estimates and therefore, also some interesting results.
And although we have not been able to diminish the presence of serial
Table 1.5: GMM estimation using q-o-q CPI inflation (three lags of
inflation added)
Z1 Z2 Z3 Z4 Z5
λ -0.023 -0.023 -0.023 -0.026 -0.016
γf 0.603*** 0.567*** 0.545*** 0.572*** 0.459***
γb1 -0.011 -0.010 0.002 -0.006 0.058***
γb2 0.539*** 0.564*** 0.575*** 0.561*** 0.566***
γb3 -0.311*** -0.280*** -0.276*** -0.278*** -0.271***
γb4 0.157** 0.122*** 0.112*** 0.117*** 0.122***
Wald 0.515 0.136 0.034? 0.203 0.002?
(0.977) (0.963) (0.960) (0.965) (0.935)
SCH 6 6 6 6 6
J-test 0.898 0.998 0.999 0.978 0.997
IV 4.34 2.63 3.31 3.42 3.67

correlation, our model alteration has improved the parameter estimates to

some extent.
If we look at the first row, we can see that the parameter estimates of
λ have negative signs using five different instrument sets. Remember that
this was not the case before. In the previous model specification when using
CPI calculated inflation, we obtained parameter estimates of the output gap
with positive sign (see Table 1.1). They are statistically insignificant in both
cases, though.
An improvement is that thanks to adding more inflation persistence in
NKPC itself, we are not able to reject the null hypothesis of the long-run
verticality of NKPC. As the two rows denoted as Wald indicate, only in
two cases we obtained p-values from the “too harsh” asymptotic Wald test
smaller than the 5% significance level. But in all cases we were not able to
reject the hypothesis when using traditional F-test.
Now, let us address the second question we wanted to answer via the
model modification. Besides the problem of serial correlation, we wanted to
know whether our estimates of the forward looking term are biased upwards
because of using lagged inflation in the instrument sets and not in the NKPC
itself.
From the Table 1.5 it is apparent that the parameter estimates capturing
deeper inflation persistence in NKPC are statistically strongly significant.
However, the effects of individual inflation lags cancel each other out to
some extent. Hence, the parameter estimates of the forward-looking term are
still the predominant ones (with the exception of the last instrument set Z5 ),
even though the cumulative effect of lagged inflation has risen to some extent
(compare with Table 1.1).
In the previous version of NKPC when using q-o-q CPI inflation the
range of γ̂f was [0.439, 0.581]. The range of the same estimate in our mod-
ified model is [0.459, 0.603]. So it is clear that the parameter estimates are
very similar and nothing indicates an upward bias of the forward-looking
parameter estimates.
But as before, last IV row indicates that the model might be weakly
identified. This hypothesis is supported to some extent by the range of our
estimates. But it has to be pointed out that our parameter estimate ranges
are much narrower than those of some other authors when facing weak iden-
tification (see e.g. Boroditskaya and Whittaker (2007)).
Let us see how the estimation results change, if we add three inflation
lags using second data specification—q-o-q IPD inflation. The results are
presented in Table 1.6.
Also using this data specification, our orthogonality conditions are met
and we can proceed with our estimation results analysis.
Again, we have not been able to rectify the problem of serial correlation.
As the SCH row suggests, it is a persistent problem of our model and ap-
pending additional lags of inflation to the model does not remove the serial
correlation.
Regarding our parameter estimates, we have reached similar results like
in the original hybrid model with only one lag of inflation (see Table 1.2). By
adding more lags of inflation we have obtained slightly smaller estimates of
the forward-looking term, but γf is still the predominant parameter in our
modified NKPC.
It has to be also noted that, as the last IV column suggests, our estimates
might be weakly identified again. This means that our point estimates might
be biased to some extent. On the other hand, our point estimate ranges
are very narrow across different instrument sets. This suggests that the bias
should not be too big.
Statistical significance of the lagged inflation terms differs from instru-
ment set to instrument set. But overall, their cumulative effect is similar as
Table 1.6: GMM estimation using q-o-q IPD inflation (three lags of
inflation added)
Z1 Z2 Z3 Z4 Z5
λ -0.074*** -0.068*** -0.068*** -0.069*** -0.069***
γf 0.770*** 0.732*** 0.746*** 0.741*** 0.745***
γb1 0.137* 0.139*** 0.134*** 0.143*** 0.139***
γb2 0.068 0.075 0.073** 0.068 0.068
γb3 0.087 0.100*** 0.096*** 0.090 0.095**
γb4 -0.023 -0.015 -0.011 -0.008 -0.011
Wald 0.120 0.089 0.011? 0.167 0.047?
(1.040) (1.032) (1.039) (1.035) (1.038)
SCH 6 6 6 6 6
J-test 0.898 0.998 0.999 0.976 0.998
IV 2.51 1.66 1.17 2.15 1.53

before, i.e. less important than the one of the forward-looking term.
When testing our hypothesis of long-run verticality we, again, can not
reject it in all five cases. As in the previous data specification, only two
instrument sets—Z3 and Z5 —gave contradicting results when testing this
hypothesis. But again, even the p-values of the asymptotic Wald test are
quite close to our 5% significance level. When using the F-test, we could
not reject the null hypothesis of verticality in any of the instrument set
specifications.
Now, let us proceed to the estimation results that were obtained when us-
ing y-o-y inflation measures. As always the CPI inflation results are reported
first.
High p-values of the J-test indicate that our orthogonality conditions hold
true.
Once again, our attempt to diminish the serial correlation was unsuccess-
ful. The Breusch-Godfrey technique gave almost zero p-values in all six tested
autocorrelation horizons in each of the six instrument sets estimations.
Table 1.7: GMM estimation using y-o-y CPI inflation (three lags of
inflation added)
Z1 Z2 Z3 Z4 Z5
λ -0.047** -0.050*** -0.053*** -0.050*** -0.046***
γf 0.573*** 0.575*** 0.583*** 0.579*** 0.562***
γb1 0.392*** 0.386*** 0.372*** 0.381*** 0.407***
γb2 0.166*** 0.177*** 0.183** 0.177*** 0.168***
γb3 0.065 0.058 0.066* 0.063 0.047
γb4 -0.190*** -0.188*** -0.197*** -0.193*** -0.179***
Wald 0.343 0.134 0.092 0.202 0.239
(1.007) (1.009) (1.009) (1.008) (1.007)
SCH 6 6 6 6 6
J-test 0.834 0.997 0.999 0.976 0.997
IV 20.78 18.43 22.29 15.71 14.25

But as in the case of added lags of q-o-q CPI inflation (see Table 1.5)
we have been able to improve our estimates to some extent. We have still
obtained the parameter estimates of the forward-looking term as the pre-
dominant ones. Inflation inertia parameter estimates are significant and their
cumulative effect is similar as in the benchmark hybrid NKPC case.
But this time, we have identified estimates of λ as statistically significant
ones. And as in the case of q-o-q CPI, the sign of these parameter estimates
have changed when we added three more lags of inflation. Now, our estimates
have negative signs, proving again that when using the single-equation ap-
proach our output gap measure struggles to perform according to economic
theory.
As in the model specification where only one inflation lag entered the
NKPC, also here the F statistics from the first-stage regression indicate
strong instruments. This can be seen in robust point estimates in Table 1.7.
Testing for long-run verticality of NKPC via the asymptotic Wald test
gave relatively high p-values. Hence, we could not reject the hypothesis of
verticality in any of the instrument set specifications.

Results of our last data specification—y-o-y IPD inflation—are reported
in Table 1.8.
Table 1.8: GMM estimation using y-o-y IPD inflation (three lags of
inflation added)
Z1 Z2 Z3 Z4 Z5
λ -0.107** -0.103*** -0.104*** -0.107*** -0.105***
γf 0.686*** 0.674*** 0.680*** 0.698*** 0.690***
γb1 0.325*** 0.345*** 0.336*** 0.311*** 0.320***
γb2 -0.036 -0.046 -0.044 -0.042 -0.044
γb3 0.399*** 0.405*** 0.413*** 0.430*** 0.428***
γb4 -0.326*** -0.332*** -0.338*** -0.347*** -0.347***
Wald 0.000 0.000? 0.000? 0.000? 0.000
(1.047) (1.045) (1.046) (1.049) (1.048)
SCH 6 6 6 6 6
J-test 0.871 0.998 0.999 0.981 0.998
IV 14.70 12.58 7.83 12.73 9.82

Again, our model has passed the test of overidentifying restrictions, as

the J-test values indicate.
As in all three previous specifications, serial correlation is still present.
Regarding the parameter estimates, we have obtained similar results as
in the case of y-o-y IPD inflation NKPC with only one inflation lag. The
forward-looking parameter estimates play again the main role. As can be
seen from Tables 1.4 and 1.8, when adding more lags of inflation we have
acquired even slightly higher estimates of γf . This rather counterintuitive
finding can be attributed to the sensitive nature of GMM estimation.
Nothing has changed by adding three more lags of inflation regarding the
estimates of parameter λ. They still have negative signs, marginal quantita-
tive effect and are statistically significant.
Similarly as in the one-inflation-lag case, parameter estimates remain ro-

bust across various instrument set estimations. Strong instruments are indi-
cated by relatively high values of the first-stage regression F-test, as well (see
last row in Table 1.8).
We have found mixed evidence for this data specification when testing
for the long-run verticality. The hypothesis was rejected in all cases by the
asymptotic Wald test and in two of them also by the F-test, although the
sums of parameter estimates are quite similar to those from Table 1.6, while
the number of parameters remains the same.24
To sum up this subsection, we have been unsuccessful in diminishing the
serial correlation from our model in all four data specifications. Therefore, we
can conclude that adding more inflation persistence in the model of NKPC
does not eliminate the problem of autocorrelation. Hence, the inflation dy-
namics as described by NKPC is not rich enough and, from the empirical
point of view, the driving forces of inflation are more complex than the the-
oretical NKPC would suggest.
Second question we addressed with our model modification was the po-
tential upward bias of the forward-looking parameter. In all four cases, the
estimates of γf still predominated and no evidence of upward bias was found.
Although our underlying findings have remained unchanged, adding three
inflation lags to NKPC has improved our estimates and particular findings
in some cases.
With our altered model we were able to confirm in all four cases that
the output gap measure gives economically incorrect results. This was due
to negative signs of estimates of parameter λ.
Galı́ and Gertler (1999) offer two possible explanations for this finding.
First, the conventional measures of the output gap are likely to be subject
to measerument errors. Hence, our output gap measure might not be a good
proxy variable for the unobservable output gap.
Second possible explanation is that the conditions under which the output
gap is proportionate to the marginal cost are not satisfied.
We offer also a third possible interpretation for this finding. Instead of
condemning the NKPC with the output gap or its measure, we rather suspect
the single-equation estimation method. In chapter 2, where we use a system
approach, we will see how our results change when we use more information
and a different estimation technique.
An improvement of our results due to the model alteration was that we
could not reject the hypothesis of long-run verticality of NKPC in any of
24
See any of the econometric publications from the Bibliography for the construction of
the F-test.
the four data specification cases. Remember that when using the benchmark
hybrid NKPC model, we rejected verticality in the q-o-q CPI inflation case.
What still remains a problem is the weak identification when using q-
o-q inflation data. Introducing a method that should give estimates robust
to weak instruments, applying this method to our model and discussion of
acquired estimation results is the subject of the following subsection.
1.4.4 Weak Identification Robust Method

We already discussed that good instruments should have two features that
in some cases might conflict. The first one is that our instruments should be
uncorrelated with the error term in our NKPC. The second property is that
they should be correlated as much as possible with the endogenous variable
that we instrument for.
Until recently, the focus of econometricians was aimed towards the first
property. This focus resulted in emergence of statistical methods that can
ensure meeting this statistical requirement (e.g. the method we use in this
thesis—GMM).
But only in recent years econometricians have turned their attention to-
wards the second statistical criterion. Soon it was pointed out that this re-
quirement was equally important and not meeting it could have serious sta-
tistical ramifications (including biased estimates). Hence, developing weak
identification robust methods has become one of the main themes in contem-
porary econometrics.
In this subsection, we present one of such methods as described and dis-
cussed in Nason and Smith (2008) and Andrew and Stock (2005). We apply
this technique to our NKPC and then discuss its drawbacks with respect to
the obtained results.
It has to be emphasized that this method allows us to estimate only the
parameter of the forward-looking term. Therefore, we will not be able to
draw any conclusions about the remaining parameters and hence, also the
long-run verticality of the NKPC can not be tested using this technique.
To describe this weak identification robust method (henceforth AR)25
we have to modify our econometric formulation of NKPC in the following
manner:
πt − γf 0 πt+1 = λyt + γb πt−1 + δut . (1.23)
The equation was modified in two ways. First, a product term of a vector
of parameters and its corresponding vector of some variables is appended.
25
This technique is based on a procedure proposed by Anderson and Rubin sixty one
years ago (Nason and Smith, 2008).
These variables basically play the role of instruments in our previous estima-
tion procedures.
Second, we have moved the forward-looking term to the left-hand side of
the equation. Now, the parameter corresponding to this term is denoted as
γf 0 . This notation indicates that it is no longer a parameter to be estimated,
it is a fixed number. While it can not be estimated, we can test different
values of γf 0 and see how the model behaves.
The idea is that we are trying to find the correct value of γf 0 that would
result in such a dependent variable πt − γf 0 πt+1 that could be explained
only by the two independent variables yt and πt−1 . Therefore, no systematic
pattern in the residuals will be detected by including other macroeconomic
variables ut (Nason and Smith, 2008).
To find this value of γf 0 with the desired property as described above, we
simply carry out a traditional F-test of the hypothesis that δ = 0, i.e. we
test the joint statistical insignificance of the variables ut .
To point out its robustness to weak instruments, note that using this
method we move the only endogenous variable to the left-hand side—making
it a part of a new dependent variable—and test the statistical insignificance
of the “instruments”. It is apparent that it does not matter whether these
instruments are strong or weak, because we do not even have to run the
first-stage regression where we would instrument for the endogenous variable
πt+1 .
And how should we find the correct value of γf 0 in practice? First, we
have to decide what variables will be included in our vector of variables ut .
Since Nason and Smith (2008) mention that including too many variables,
especially those that are irrelevant as instruments, might result in too wide
confidence intervals, we include only the most correlated variables with πt+1 .
Hence, our vector of auxiliary variables has the following structure: ut =
[πt−2 , πt−3 , U Rt , rt , ∆rERt ].
As before, U R stands for the unemployment rate, r represents the two-
week REPO interest rate at the end of each quarter and ∆rER is the first
difference of the logarithm of real exchange rate CZK/EUR.
With auxiliary variables determined, we have to create a fine grid of values
of γf 0 ranging from 0 to 2 (as Nason and Smith (2008) did). We use a grid
of 100 equally spaced points between 0 and 2. Then, we run the regression
in a loop saving the values of the F statistic from our F-test for each of the
100 points. We use ordinary least squares (OLS) estimation technique.
Values from our grid corresponding to the values of the F statistic, that
exceed the critical value from the F distribution, form the 1 − α confidence
interval for the parameter γf . The point in grid corresponding to the smallest
value of the F statistic can then be perceived as the point estimate of γf .
Figure 1.1: AR method estimation results
The results using the AR method are presented in graphical form in Figure
1.1. Again, the calculations were conducted in Gretl, the graphical output
was produced using Matlab.
We can see that the AR technique completely fails when using q-o-q
CPI inflation data. The point estimate of γf is even beyond our 0–2 range.
Any value exceeding 2 as the estimate of parameter γf would be simply
too high by any reasoning. Furthermore, the method fails to provide any
confidence interval. All values of the F statistic lie above the 5% critical
value F (5, 45) = 2.42 that is represented by the green lines in Figure 1.1.
When using q-o-q IPD inflation, we have obtained a point estimate ca.
0.87 of the forward-looking parameter γf . This estimate is not too far from
our previous results when using q-o-q IPD inflation. In our benchmark model
with this data specification, the point estimate range was [0.797, 0.821] (see
Table 1.2). And when we corrected the NKPC model for deeper inflation
persistence, the range became [0.732, 0.770] (see Table 1.6).
In this data specification, some of our F statistic values lie under the
critical value, but this time we face a different problem when using the AR
method. Our 95% confidence interval is too wide, in our case it spreads
even beyond our maximal value for γf 0 . So this method suggests that the
confidence interval ranges from 0.29 beyond 2. The problem of too wide
confidence intervals is quite common when using the AR method (Nason
and Smith, 2008).
More reasonable results were obtained when we used the y-o-y data. In
particular, with y-o-y CPI inflation we computed the point estimate of γf as
0.48. This figure, again, lies quite close to our previous estimate ranges. The
benchmark model with y-o-y CPI inflation produced range [0.510, 0.528] (see
Table 1.3) and for deeper inflation persistence corrected model was estimated
with the range of [0.562, 0.583] (see Table 1.7).
The 95% confidence interval for our parameter γf is much narrower than
before, specifically [0.42, 0.56].
Using last data specification—y-o-y IPD inflation—we obtained similar
results as with the previous data specification, only with wider confidence
interval. Concretely, our point estimate is ca. 0.53 and the 95% confidence
interval is [0.28, 0.74].
But when we estimated the model using the GMM our point estimates
ranges were [0.603, 0.615] for the benchmark model and [0.674, 0.698] for the
corrected model.
Overall, we may conclude that the AR method totally fails if the q-o-q
CPI data are used. But it gives relatively reasonable results with q-o-q IPD
(but yields too wide a confidence interval) and the y-o-y data. And even then,
it seems that the point estimates are somewhat biased in comparison with
our GMM results.
And at this point we must stress the fact that the model using GMM
on y-o-y data was strongly identified, i.e. our instruments were strong and
therefore, the variation of estimates across different instrument sets was very
small. This would imply that when using the AR method we should obtain
the same (or at least very similar) results as in the GMM identification. But
this was not the case. So why did the AR technique completely fail when
using q-o-q CPI data and give biased results when using y-o-y data?
The answer to this question lies in the rather strict assumptions. The
technique provides its user with accurate results only when the following as-
sumptions are satisfied. First of all, the output gap has to be exogenous. The
requirements concerning the error term include i.i.d. process. Furthermore,

to be able to compare our computed F statistic with a cricital value from the
F distribution, the errors should be normally distributed. Therefore, the AR
method is not robust to heteroskedasticity and/or autocorrelation (Andrew
and Stock, 2005). Let us now check, if the assumptions are satisfied.
All of the tests were conducted using 7 different values from the grid of
γf 0 , concretely [0.1818, 0.3838, 0.5859, 0.7879, 0.9899, 1.3939, 1.7980].
When testing for the exogeneity of the output gap we carried out the
Hausman endogeneity test. The instruments for the output gap were its two
lagged values.
First data specification—q-o-q CPI inflation—showed that using first five
of the seven above specified grid values we found evidence of the output gap
being endogenous on the 5% level of significance. This result might explain
the huge bias of the point estimate in the first data specification case, since
the exogeneity of the independent variables is a very important property.
Using second and third data specifications—q-o-q IPD and y-o-y CPI—
we could not reject the null hypothesis of the exogeneity of the output gap.
When using the fourth type of inflation—y-o-y IPD—the output gap was
tested being endogenous with 95% confidence. But this was the case only
when the first two values from our shortlisted grid were applied, remaining
five values led us to not rejecting the exogeneity hypothesis.
These results should explain to some extent why the individual point
estimates calculated utilizing the AR technique were so far or relatively near
the particular GMM estimates.
What about the assumptions concerning the error term? First, we check
for the presence of autocorrelation. Again we use the Breusch-Godfrey test.
In all four data specifications we were able to reject the null hypothesis of no
autocorrelation at the 5% level of significance. Specifically, when using q-o-q
data we found evidence of AR(1)/MA(1) process.26 y-o-y data demonstrated
serial correlation of even higher order (in most cases around 4, depending on
the value from our shortlisted grid).
The presence of serial correlation in all four cases undermines the relia-
bility of the acquired results. Remember that we did not obtain the point
estimates using OLS (in that case, our point estimates would still be unbi-
ased). Although we did utilize OLS, our point estimate was acquired as the
minimum of the F statistic values. And the accuracy of the F statistic hinges
on the assumption of no serial correlation. Therefore, not only our confidence
intervals estimates but even our point estimates are biased in all four cases.
26
Remember that Breusch-Godfrey tests the hypothesis of no serial correlation against
the alternative AR(p)/MA(p).
Next, we tested the heteroskedasticity. We did this by carrying out the

robust variant of Breusch-Pagan test. We did not reject the null hypothesis
of homoskedasticity in all four data specification with the exception of y-o-y
CPI inflation. There we faced mixed results depending on the values of γf 0 .
When first three values from our shortlisted grid were applied, we rejected
the null in favor of the alternative—heteroskedasticity. Using remaining four
values of γf 0 resulted in not rejecting the hypothesis of homoskedasticity.
Overall, we may say that the assumption of the same variance throughout
the time series was satisfied.
Last property to check was the normality of the error term. The worst
results were found on q-o-q CPI data which also produced the worst estima-
tion results. We rejected the null hypothesis of normality in five of the seven
cases tested. q-o-q IPD and y-o-y CPI demonstrated normal residuals with
any of γf 0 values. y-o-y IPD inflation showed non-normal residuals in only
two cases and the p-values of these tests were quite close to our 5% level of
significance. Altogether, we may argue that considerable non-normality was
found only in the q-o-q CPI data.
In conclusion of this subsection, one can say that the AR method results
are quite unreliable. This was particularly the case when the q-o-q CPI data
were used. The causes of this failure were identified primarily as endogene-
ity of the output gap, then also serial correlation and non-normality of the
residuals.
The three remaining data types estimates were also slightly biased. This
was due to the serial correlation which was identified in all four data speci-
fications. But this bias was not as substantial as in the q-o-q CPI case and
the results were relatively close to the GMM estimates.
But if we consider that we were trying to obtain more precise estimates
on q-o-q data—we already strongly identified NKPC on y-o-y data using
GMM—we were not overly successful. CPI inflation estimation went totally
wrong and IPD inflation produced slightly biased estimate.
One way how to completely circumvent the problem of endogenous vari-
able πt+1 and thus, also the issue of weak identification is to utilize more
information from additional relationships between variables. This leads us to
a system of equations approach. Estimating a simultaneous-equations model
containing our hybrid NKPC will be the subject of the following chapter.
Chapter 2
DSGE Approach
In chapter 1, we estimated NKPC via the single-equation approach. Although

we were able to acquire convincing results when using y-o-y data, usage of q-
o-q data resulted in weak identification. This caused relatively wide range of
parameter estimates across various instrument sets. Not even employing one
of the weak identification robust methods—specifically, the AR technique—
could rectify this problem.
Therefore, we cope with the problem of endogeneity in different manner.
We set the NKPC in a simultaneous-equations model. To be specific, we
estimate a simple dynamic stochastic general equilibrium (DSGE) model for
a closed economy. This type of model is also derived from New Keynesian
microeconomic foundations and NKPC is one of its building blocks.
This chapter is structured as follows. Section 2.1 presents the basic New
Keynesian model. In section 2.2, we very briefly introduce the Bayesian esti-
mation approach that we use to identify our model. In section 2.3, we discuss
the obtained results.
2.1 Simple DSGE Model

The model we employ in this chapter is the most basic type of DSGE model
and was published in Cho and Moreno (2006). It contains only three equations
describing the demand and supply side of the economy and the behaviour of
central bank determined by a Taylor rule.
We could not reject the hypothesis of the long-run verticality of the Czech
NKPC in vast majority of data or model specifications in chapter 1. Con-
sidering this fact, we use a model which contains this property of long-run
verticality. That is, the restriction γf + γb = 1, as was described in section
48 DSGE Approach
1.1 (see equation (1.4)), is applied in our model.1

This approach is a standard one in literature when dealing with this kind
of three-equation model. It stems from the generalization of the forward-
looking equations in our model, as derived in Clarida et al. (1999). Besides
that, it ensures credible parameter estimates and consequently their plausible
economic interpretation.
Again, as in section 1.1, we do not explicate the exact derivation of our
model. Instead, we only present the resulting equations of our model.2
Let us start with our hybrid NKPC. This equation describes the supply
side of the economy and has the following form:
πt = λyt + δEt {πt+1 } + (1 − δ)πt−1 + εASt , (2.1)
where εASt is assumed to be an independently and normally distributed ran-

2
dom variable, i.e. εASt ∼ N (0, σAS ). It can be thought of as a supply shock.
Again, the proportionate relation between the gap in marginal cost and
the output gap is assumed so that NKPC, originally derived with the gap in
marginal cost as the driving variable, features the output gap.
Next equation, the IS equation, describes the demand side of the economy.
It is defined as follows:
yt = µEt {yt+1 } + (1 − µ)yt−1 − φ(rt − Et {πt+1 }) + εISt , (2.2)

2
where rt is nominal interest rate and εISt ∼ N (0, σIS ) is the demand shock.
This nominal interest rate is the central bank’s monetary policy instrument.
Thus, the output gap depends on the convex combination of its past and
expected value. The term in the parenthesis whose influence is measured by φ
and that negatively affects the dynamics of the output gap is the real interest
rate.
The model is closed with an equation that describes the behaviour of the
monetary authority. The Taylor rule has the the following form:
rt = ρrt−1 + (1 − ρ)[βEt {πt+1 } + γyt ] + εM P t ,3 (2.3)

1
In literature, this parameter restriction is often imposed even in the single equation
estimation. See for example Menyhért (2007).
2
For derivation, see for example Clarida et al. (1999) or references in Cho and Moreno
(2006) whose model we utilize here.
3
If you look in Cho and Moreno (2006), you would find out that this equation differs
from the one therein by a constant term. Here, we present the model already in the
demeaned form, so we have got rid of the constant term. Cho and Moreno (2006) also
use the demeaned version of the model during estimation via full information maximum
likelihood method.
2.2 The Bayesian Estimation 49
2
where εM P t ∼ N (0, σM P ) is the monetary policy shock.
It is apparent that the monetary authority smoothes the dynamics of
the interest rate. This smoothing is captured by the parameter ρ. Besides
that, the central bank also reacts to developments in expected inflation and
current output gap. These responses are captured by the parameters β and γ,
respectively. The reaction to the joint effect of expected inflation and current
output gap is weighted by the term (1 − ρ).
Each of the equations (2.1), (2.2) and (2.3) contains the forward- and
backward-looking endogenous term. This is the result of the previously men-
tioned generalization in derivation of the model by Clarida et al. (1999).
As before, Et is the rational expectations operator conditional on the in-
formation set available at time t. Whereas in the estimation process in chapter
1, this information set included various macroeconomic variables helping pre-
dict the future inflation (our instruments), here, the expectations are based
solely on our three endogenous variables πt , yt , rt and their developments
throughout the measured period.
Let us now proceed to the brief description of the method that we utilized
to simultaneously estimate our model consisting of equations (2.1), (2.2) and
(2.3).
2.2 The Bayesian Estimation

This section is devoted to a rather intuitive explication of the Bayesian esti-
mation, following mainly Mancini (2009) and Koop (2003).
The principle of this method is fusion of our a priori knowledge about the
model, particularly the parameters, and the information obtained from the
data. This is done through the Bayesian principle known from statistics.
First, let us define our a priori knowledge, i.e. our prior density function:
p(θ).
This is the probability density function of the vector of parameters θ

before confronting our model with data.
Next, we define the likelihood function which is the joint probability den-
sity function of the observed data conditioned by the parameters:
p(Yn |θ),
where Y n is the vector of n observed data.

We are, of course, interested in the posterior density function, or simply
posterior. It can be obtained by applying twice the definition of conditional
50 DSGE Approach
probability density function:

p(θ; Yn ) p(Yn |θ)p(θ)
p(θ|Yn ) = = ,
p(Yn ) p(Yn )
where in the numerator we have our likelihood function and prior and in the
denominator p(Yn ). The term in the denominator is the marginal density of
the data retrieved from the joint probability density function:
Z
p(Yn ) = p(θ; Yn )dθ.
Θ
Then, since the marginal density defined above does not depend on the
parameters of interest, we can write that the posterior kernel4 is proportion-
ate to the numerator. Hence:
p(θ|Yn ) ∝ p(Yn |θ)p(θ) ≡ K(θ|Yn ).
From this equation, we can already retrieve the posterior moments that we
are interested in. But before we can do it, we have to estimate the likelihood
function. To do this, we use Kalman filter. We will not cover the explication
of Kalman filter here. Instead, for interested readers, we recommend reading
chapter 13 of Hamilton (1994).
The next step in our estimation procedure is finding the mode of the pos-
terior distribution which is important for employing the Metropolis-Hastings
algorithm in the subsequent phase. To find the mode, we maximize the log
posterior kernel—estimated via Kalman filter in the previous step—with re-
spect to θ. This is done numerically.
Since the kernel of our posterior distribution can not be expressed in an
analytical form, we have to resort to a sampling method, in our case, the
Random Walk Chain Metropolis-Hastings algorithm (RWC M-H). This al-
gorithm is one of the Markov Chain Monte Carlo (MCMC) methods. Shortly,
it will become clear why.
The algorithm can be described in following steps:
1. First, we have to determine our starting vector θ 0 . Usually, it is our

previously computed posterior mode.
2. Then, we have to draw a candidate vector θ ∗ from a drawing distribu-

tion
N (θ s−1 , cΣm ),
4
Kernel is a density that is not normalized, i.e. density whose integral across the whole
domain is not equal to 1. It is because we omit the constant that ensures this normalization.
2.2 The Bayesian Estimation 51
where Σm is the inverse of the Hessian computed at the posterior mode

and c is the scale factor.
The distribution is a multivariate normal distribution with θ s−1 being
its mean and cΣm its variance matrix.
3. Next, we compute the acceptance ratio
p(θ ∗ |Yn ) K(θ ∗ |Yn )
r= = .
p(θ s−1 |Yn ) K(θ s−1 |Yn )
We simply evaluate our posterior kernel at values θ ∗ (which is our

candidate vector) and θ s−1 (which is the mean of our drawing distri-
bution), respectively. Then, we compare these two values to obtain the
acceptance ratio.
4. In the final step of the loop, we accept or reject the candidate θ ∗ . The
decision is based on the following rule:
(
s θ∗ with the acceptance probability α = min[r, 1]
θ = s−1
θ with the acceptance probability 1 − α
The loop is closed by returning to the second step.

It is apparent that the construction of the acceptance probability ensures
that we move towards regions of higher posterior probability, while choosing
candidates from our drawing distribution.
To see why we draw candidates from multivariate normal distribution,
we have to clarify how the RWC M-H moves in the posterior kernel. The
algorithm generates draws according to a random walk process (Koop, 2003).
In one dimensional case, random walk process is a special case of AR(1)
process where the parameter equals 1. Hence in our case, the random walk
takes form θ ∗ = θ s−1 + z, where z ∼ N (0, cΣm ).
Hence, the state of the RWC M-H at draw θ ∗ depends on the state at the
previous draw θ s−1 . Thus, we see that the sequence of draws is a so-called
Markov chain.
The whole procedure of the RWC M-H, as described above, is repeated S
times. To ensure that we got rid of the influence of our initial values θ 0 , we
discard first S0 draws. The remaining S − S0 draws are averaged to retrieve
the posterior mean. This procedure is called the Monte Carlo integration.
To be sure that our initial values do not affect our results, it is important
to use some MCMC convergence diagnostics. We do not deal with those in
this thesis, though, and recommend seeing Koop (2003) for more information
on this topic.
52 DSGE Approach
2.3 Estimation Results

In this section, we present our estimation results. But first, let us comment
on the used data and the type of our model in the context of the estimation
procedure carried out by our estimation software—Dynare.
Dynare is a Matlab toolbox that has a built-in solution to the rational
expectations models. This means that via Dynare, we can easily check,
whether the so-called Blanchard-Kahn condition is satisfied. The Blanchard-
Kahn condition tells us that the solution to a rational expectations model is
unique if and only if the number of stable eigenvalues, i.e. eigenvalues less
or equal to 1 in absolute value, is equal to the number of predetermined
variables, i.e. variables whose value we know in time t (Beneš, 2000).
In general, before Dynare estimates a model, it first linearizes it around
a steady state (Mancini, 2009). For Dynare to be able to compute this
steady state, we have to provide it with some initial values of our variables.
The catch is that if we do not know what the steady state might be and
therefore our initial values are relatively far from this steady state, Dynare
might not compute the steady state correctly or even at all.
But thanks to the fact that our model is linear, we can work with the
model(linear) option that Dynare offers. This option implicitly considers
the model as being in the gap form, i.e. that the steady states are all 0.
For our model in the gap form to be consistent with our data, we have to
transform them in the gap form as well.
Instead of applying the Hodrick-Prescott filter, we simply demean the
time series πt and rt . Thus, we use the centered variables. The reason for
this is that we want to leave our results from chapter 1 as comparable with
results from this chapter as possible. Employing the Hodrick-Prescott filter
would change our time series in such a fashion that this comparison would
not be possible.
The variable yt remains unchanged, since it already is a gap variable. Cho
and Moreno (2006) also estimated the model in the demeaned form, although
they used the full information maximum likelihood estimation technique.
Hence, our approach is consistent with the one used in literature.
As in the estimation section 1.4 in chapter 1, we estimate our three-
equation model using all four inflation measures again.
Our three endogenous variables are πt , yt , rt . Inflation measures (only
centered in this chapter) and the output gap remain the same as in chapter
1. rt is measured as the centered two-week REPO interest rate at the end of
each quarter. It is, because rt represents the monetary policy instrument in
our model and Czech National Bank’s (CNB) key instrument is the two-week
REPO interest rate.
Before we can estimate our model, we have to specify the priors for our
parameters. The priors are set in the following fashion.
For the parameters of interest, we use the beta distribution. Specifically,
we use the standard beta distribution, that is defined on interval [0, 1], for
parameters that follow this range restriction. In our model, these parameters
are δ, µ and ρ. Since we do not want to bias the posterior estimates of these
parameters one way or the other, we set the prior means to 0.5.
Priors of λ and φ follow rescaled beta distribution that is defined on
interval [−10, 10]. We set the prior means to 0.1 in both cases. The same
value is set as the standard deviation of all the priors so far.
The two remaining parameters are β and γ. These parameters should
assume positive values to be consistent with our economic intuition. We ex-
pect the central bank to react to positive expected inflation by increasing
the interest rate. The same reaction would be expected in case of positive
output gap. Thus, we use the rescaled beta distribution again. This time it
is defined on interval [0, 10].
But since CNB conducts its monetary policy in the inflation targeting
regime, we would expect the weight of expected inflation being much bigger
than the one of the output gap. Therefore, we set the prior means of β and
γ equal to 1.5 and 0.5, respectively. As we are not particularly sure of these
“guesses”, we set the standard deviations of these priors to 0.2.
Besides these parameters, Dynare also estimates the standard devia-
tions of our shocks. We have to determine the prior distributions for these
parameters as well. We use the inverse gamma distribution, as it is defined on
R+ . Our prior means are set to 0.5 and because these are very rough guesses,
we leave these priors as being noninformative, i.e. we set their standard de-
viations to infinity.
The prior distributions, along with the posterior distributions, for all four
inflation-measure specifications are depicted in appendix A.
To estimate our model, we ran 400 000 replications of the RWC M-H
algorithm in five blocks. Then, we discarded first 180 000 draws to ensure
that our results converge to the values we were looking for. Hence, the Monte
Carlo integration was carried out on 220 000 draws.
The MCMC convergence diagnostics showed that we reached convergence
in every single case. Therefore, we do not present the convergence results,
since they are not of a particular interest to us.
The estimation results using the centered q-o-q CPI inflation are pre-
sented in Table 2.1.
Estimates of the most important parameters to us—the parameters in
the NKPC, δ and λ—are 0.6806 and 0.0054, respectively. This shows that
the degree of the predominance of the forward-looking term is slightly larger
54 DSGE Approach
Table 2.1: Bayesian estimation using q-o-q CPI inflation
Prior mean Prior std Posterior mean HPDI (95%)

δ 0.500 0.1000 0.6806 0.5943 0.7674
λ 0.100 0.1000 0.0054 0.0000 0.0145
µ 0.500 0.1000 0.4923 0.3917 0.5728
φ 0.100 0.1000 0.0067 -0.0000 0.0159
ρ 0.500 0.1000 0.8221 0.7643 0.8814
β 1.500 0.2000 1.5372 1.2017 1.8686
γ 0.500 0.2000 0.5698 0.2284 0.8942
σAS 0.500 ∞ 0.8061 0.6578 0.9471
σIS 0.500 ∞ 0.5327 0.4263 0.6377
σM P 0.500 ∞ 1.3533 1.1053 1.5986
than any of our estimates in chapter 1 (see Table 1.1 for the benchmark
model estimates and Table 1.5 for the corrected model estimates). But as was
already emphasized, our GMM estimation using q-o-q data was subject to
weak instruments problem, so our results from the single-equation approach
lack robustness.
Another interesting fact is that the estimate of λ, proxy of our real variable
(output gap) in the NKPC, has positive sign. It is also statistically significant,
as the 95% Highest Posterior Density Interval (HPDI, the Bayesian analogy
to the traditional confidence interval) suggests.
This change arises from setting the NKPC in a system of mutually in-
terconnected equations where also the output gap has its own dynamics and
its place in the NKPC is therefore “substantiated”, so to speak, by its own
equation. So while in a single equation describing the inflation dynamics,
the output gap might struggle to give economically correct results, in the
interdependent system of equations, the output gap performs as it should, at
least considering its sign. On the other hand, it has a negligible quantitative
effect on the inflation dynamics.
Estimate of parameter µ indicates that in the output gap dynamics, the
forward- and backward-looking terms are roughly equally important for the
economic agents. Estimate of the other parameter from the IS equation, φ,
suggests that an 1% increase in real interest rate would result in a decrease

of the output gap by 0.0067%. However, we can see from the Table 2.1 that
this estimate is statistically insignificant, because the HPDI contains zero, as
well.
Parameter estimates of the Taylor rule imply following monetary policy
conduct. We identified very strong smoothing pattern of the interest rate
(ρ̂ = 0.8221). The overall weights were estimated to be 0.2735 and 0.1014 for
the expected inflation and for the output gap, respectively.
These results are in line with our a priori assumptions about the CNB’s
monetary policy priorities. We assumed that, since CNB follows inflation tar-
geting strategy, it would react more strongly to changes in expected inflation
than to output gap variation. It turns out that the estimated weight for the
expected inflation is ca. 2.7 times bigger than the weight of the output gap.
How our results change when we use q-o-q IPD measure of inflation can
be seen from Table 2.2.
Table 2.2: Bayesian estimation using q-o-q IPD inflation

δ 0.500 0.1000 0.6269 0.5442 0.7197
λ 0.100 0.1000 0.0051 0.0000 0.0126
µ 0.500 0.1000 0.4927 0.3976 0.5725
φ 0.100 0.1000 0.0064 0.0000 0.0144
ρ 0.500 0.1000 0.8157 0.7551 0.8748
β 1.500 0.2000 1.5734 1.2271 1.9073
γ 0.500 0.2000 0.5777 0.2394 0.8994
σAS 0.500 ∞ 0.6545 0.5312 0.7715
σIS 0.500 ∞ 0.5326 0.4261 0.6367
σM P 0.500 ∞ 1.3335 1.0889 1.5737
It is obvious that the estimates are very similar to our previous results.
Biggest difference can be seen in the new estimate of δ, which is now 0.6269.
But even this value is quite close to the previous estimate of 0.6806. Second
thing to notice is that this time, the estimate of φ is statistically significant,
but of similar quantitative magnitude.
56 DSGE Approach
Table 2.3: Bayesian estimation using y-o-y CPI inflation

δ 0.500 0.1000 0.4756 0.3743 0.5584
λ 0.100 0.1000 0.0262 0.0000 0.0598
µ 0.500 0.1000 0.5005 0.4351 0.5682
φ 0.100 0.1000 0.0093 0.0000 0.0203
ρ 0.500 0.1000 0.7678 0.6961 0.8424
β 1.500 0.2000 1.3924 1.1295 1.6490
γ 0.500 0.2000 0.4134 0.1587 0.6690
σAS 0.500 ∞ 0.7883 0.6261 0.9458
σIS 0.500 ∞ 0.5287 0.4288 0.6244
σM P 0.500 ∞ 1.2944 1.0592 1.5209
Hence, we can conclude that the estimation results are robust to different
price index measures of inflation when using the q-o-q data in our three-
equation model.
Let us see what estimates we obtain, if we use the y-o-y data. First, we
report the CPI inflation results in Table 2.3.
Although most of the estimates are quite close to our previous results,
we can also find some considerable differences. And it is no surprise that the
most striking differences can be found in the NKPC equation. While when
using q-o-q data, the forward-looking term predominated, we obtain different
results when the y-o-y data are used.
Here, the estimate of δ suggests that the forward- and backward-looking
terms are of similar importance to economic agents (the backward-looking
term is even slightly the more important one). This finding is somewhat
different from our results from chapter 1 (see Table 1.3 for the benchmark
model estimates and Table 1.7 for the corrected model estimates).
There, we also identified smaller weight for the expected inflation with
y-o-y data than with q-o-q data, yet, we found the forward-looking term to
be quantitavely more important to economic agents.
The estimate of λ has the correct sign once again and this time is of larger
magnitude than before. Now, an 1% increase in output gap would lead to
0.026% increase in inflation (in comparison with 0.005% reaction that was
recorded before).
The smallest changes in parameter estimates can be found in the IS equa-
tion where the parameters µ and φ determine the output gap dynamics.
Again, the forward- and backward-looking terms are equally weighted, while
the real interest rate has only slightly bigger effect on the output gap.
The estimates of the Taylor rule bring similar underlying conclusions,
however, the quantitive effects are slightly different than before. Specifically,
the interest rate smoothing—captured by the estimate of ρ—is not as strict
as before.
Furthermore, the overall weight for the expected inflation is somewhat
higher - 0.3233. The output gap is estimated to be weighted by 0.0960. Thus,
the ratio of priorities is higher than before in favor of the expected inflation
- ca. 3.4.
Our last data specification—the centered y-o-y IPD inflation—gave very
similar results. They are reported in Table 2.4.
Table 2.4: Bayesian estimation using y-o-y IPD inflation

δ 0.500 0.1000 0.4564 0.3494 0.5503
λ 0.100 0.1000 0.0252 0.0000 0.0571
µ 0.500 0.1000 0.5032 0.4417 0.5662
φ 0.100 0.1000 0.0098 0.0000 0.0206
ρ 0.500 0.1000 0.7182 0.6323 0.8020
β 1.500 0.2000 1.4273 1.1812 1.6693
γ 0.500 0.2000 0.4929 0.2099 0.7619
σAS 0.500 ∞ 0.7904 0.6222 0.9589
σIS 0.500 ∞ 0.5330 0.4306 0.6290
σM P 0.500 ∞ 1.2663 1.0427 1.4848
Thus, the results—as in the case of q-o-q data—are robust to price index
that is utilized to compute the y-o-y inflation.
To conclude this chapter, we may argue that we have succesfully circum-
vented the problem of endogenous variable and consequent weak identifica-
58 DSGE Approach
tion by setting the NKPC in a system of interdependent equations.

Besides that, we were able to utilize more information from the model
to estimate the output gap parameter with the economically correct sign. In
chapter 1 on the contrary, we concluded that the output gap measure was not
able to perform as it should. This change of results may be viewed as another
advantage of DSGE model estimation in comparison with the single-equation
econometric approach.
Regarding particular results, we were able to confirm the predominance
of the forward-looking term in the NKPC using q-o-q data. This finding is in
line with conclusions of other authors (e.g. Cho and Moreno (2006) or Galı́
and Gertler (1999)).
On the contrary, when using y-o-y data which is not that usual in litera-
ture, we identified the lagged inflation as the slightly predominant factor in
y-o-y inflation dynamics.
Our results were robust to the price index used to compute the inflation,
in both q-o-q and y-o-y data specifications.
To briefly sum up also results from other equations of our model, we
can say that the forward- and backward-looking term in the IS equation are
equally important. The effect of the real interest rate is quite marginal.
The parameters of the Taylor rule were estimated as expected. CNB
strongly smoothes out the two-week REPO interest rate and the expected
inflation is roughly 3 times more important variable than the output gap
when conducting monetary policy.
Conclusion
In this thesis, we analyzed the inflation dynamics in the Czech Republic. The
New Keynesian framework was utilized, in particular the hybrid version of
New Keynesian Phillips curve (NKPC) that has been frequently discussed in
literature in recent years.
Since in the model framework, there is no clear indication what inflation
measure to use, we compared four different inflation types. We utilized q-o-
q and y-o-y inflation. These measures were computed from consumer price
index (CPI) and implicit price deflator (IPD).
Besides analyzing our results across four different inflation measures, we
also tested the long-run verticality of the NKPC. The last analyzed problem
in this thesis was the performance of the driving variable in the NKPC - the
output gap.
First, we estimated the NKPC via single-equation approach. We employed
the generalized method of moments (GMM). Using the q-o-q data resulted
in weak identification which is a frequently reported problem in literature
when estimating the NKPC.
The expected inflation was estimated to be the more important term in
the NKPC, using both q-o-q and y-o-y data. It has to be noted, though, that
the predominance of the forward-looking term was not that apparent when
using y-o-y data.
The GMM estimation was quite sensitive to the data used. There were
considerable quantitative differences when we compared CPI and IPD results.
Nevertheless, the underlying conclusions remain the same.
The evidence of long-run verticality of the NKPC was found in three of
the four used inflation measures (the exception was the q-o-q CPI inflation).
However, when we allowed for deeper inflation inertia, we could not reject
the long-run verticality of the NKPC in any of the four data specifications.
A persisting problem in our single-equation estimation that we were not
able to rectify was the serial correlation. This implies some omitted dynamics
in the NKPC and thus, at least from the empirical point of view, the inflation
determinants are more complex than the theoretical NKPC would suggest.
60 Conclusion
Yet, it may still serve as a good approximation of inflation dynamics as we

saw in chapter 2.
The problem of weak identification when using the q-o-q data was tackled
via a weak identification robust method (the AR method). But obtaining re-
liable results from this method was unsuccessful, since some of the conditions
for use of this method were not met.
Thus, to deal with the problem of weak identification, stemming from
the endogeneity of one of the variables, we set the NKPC in a system of
interdependent equations. This system is a basic DSGE model derived from
microeconomic foundations. This allowed us to completely avoid the problem
of endogeneity.
The three-equation model was estimated via the Bayesian method us-
ing the Metropolis-Hastings algorithm. The system estimation confirmed the
predominance of the expected inflation in the NKPC, but only when using
q-o-q data. When utilizing the less volatile y-o-y data, we found that the in-
flation persistence plays the slightly more important role. These results were
very robust to price index used to compute the inflation.
Concerning the performance of the driving variable—the output gap mea-
sure—in the single-equation estimation, we obtained unambiguous results
only when we corrected the NKPC model for more inflation persistence. The
finding was that of Galı́ and Gertler (1999), i.e. that the output gap measure
does not perform well in the NKPC (we obtained statistically significant
negative parameter estimates). Galı́ and Gertler (1999) argued that the most
likely cause of this failure is that the conditions under which the output gap
corresponds to marginal cost may not be satisfied.
We offer another explanation in the light of the results from chapter 2.
We perceive the economically correct estimates in the system estimation as
a direct consequence of the strict microeconomic derivation of the system
that provides us with additional information about the inflation dynamics
that the single-equation approach lacks. Thus, this can be seen as yet an-
other advantage of the DSGE estimation approach besides dealing with the
endogeneity problem.
For these reasons we recommend the system estimation of the NKPC
over the single-equation GMM estimation. The GMM is very sensitive to
particular data one utilizes and since it draws from asymptotic theory, it
may work better on longer time series which a transitive economy with a
monetary regime shift such as the Czech Republic can not provide yet.
Overall, we conclude that the hybrid NKPC may serve as a good approx-
imation of the inflation dynamics. The predominance of the forward-looking
term in the more often used q-o-q data shows that it may fit the data better
than the traditional backward-looking-only Phillips curves.
61
On the other hand, the original—forward-looking-only—NKPC suggests

that there are no disinflation costs. Hence, inflation can be costlessly con-
trolled by a credible commitment to keep the current and future output close
to its potential level (Rudd and Whelan, 2005).5
But our empirical results, showing strong statistical and also quantitative
significance of the backward-looking term, imply that CNB can not achieve
new level of inflation immediately and costlessly. Hence, these results justify
the use of the hybrid version of the NKPC over the original forward-looking-
only NKPC.
5
This would become obvious if we iterated forward the counterpart of equation (1.1),
where the output gap would feature as the real variable.
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Appendix A
DSGE Estimation Figures
In this appendix, we present the graphical output from Dynare estimation

of our basic DSGE model. The figures show the prior densities (grey curves),
posterior densities (black curves) and the posterior modes (grey vertical lines)
of the estimated parameters and standard deviations of shocks.
It can be seen that in some graphs, the green dashed line is not exactly
at the mode of the posterior distribution. This is because the green line is
calculated from the numerical optimization of the posterior kernel (Mancini,
2009). In all cases though, it is close enough to the mode of the posterior
distribution computed by the Random Walk Chain Metropolis-Hastings al-
gorithm.
66 DSGE Estimation Figures
Figure A.1: Priors and posteriors (q-o-q CPI inflation)

67
Figure A.2: Priors and posteriors (q-o-q IPD inflation)

68 DSGE Estimation Figures
Figure A.3: Priors and posteriors (y-o-y CPI inflation)

69
Figure A.4: Priors and posteriors (y-o-y IPD inflation)

Estimating New Keynesian Phillips Curve Single Equation vs. DSGE Approach

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Masaryk University

Faculty of Economics and Administration

Estimating New Keynesian

Odhad Novokeynesiánské Phillipsovy křivky:

Diplomová práce se zabývá analýzou inflačnı́ dynamiky v České republice. Ta

New Keynesian Phillips Curve, generalized method of moments, DSGE, Ba-

Novokeynesiánská Phillipsova křivka, zobecněná metoda momentů, DSGE,

April 25, 2010 in Brno .....................................

1 Single Equation Approach 10

A DSGE Estimation Figures 65

1.1 GMM estimation using q-o-q CPI inflation . . . . . . . 25

2.1 Bayesian estimation using q-o-q CPI inflation . . . . . . 54

Short-run inflation dynamics is one of the most debated topics in macroeco-

Subject of chapter 2 is the Bayesian estimation of NKPC as a part of a

Single Equation Approach

Subject of this chapter is the identification of NKPC as a single equation and

1.1 Hybrid New Keynesian Phillips Curve

πt = κ mct + βEt {πt+1 } (1.1)

πt = κ mct + γf Et {πt+1 } + γb πt−1 , (1.2)

and φ ≡ θ + ω[1 − θ(1 − β)].

An interesting case of NKPC can be obtained by setting the discount

πt = κ mct + (1 − δ)Et {πt+1 } + δπt−1 , (1.4)

πt = λyt + γf Et {πt+1 } + γb πt−1 , (1.5)

1.2 Econometric Hybrid New Keynesian Phil-

E[πt+1 |zt ] = E[E(πt+1 |It )|zt ]. (1.6)

And if we regress the unobserved forecast on the instruments: E[πt+1 |It ] =

E[E(πt+1 |It )|zt ] = βzt ,

which by the result from (1.6) yields

E[πt+1 |zt ] = βzt .

E[πt+1 |It ] = E[πt+1 |zt ] + ηt . (1.7)

πt = λyt + γf E[πt+1 |zt ] + γb πt−1 + γf ηt (1.8)

This econometric equation of the hybrid NKPC might be identified by

E[πt − λyt − γf E[πt+1 |It ] − γb πt−1 |zt ] = 0.

E[πt − λyt − γf πt+1 − γb πt−1 |zt ] = 0. (1.9)

Now it is obvious that we have got a typical econometric requirement,

E[εt |zt ] = 0. (1.10)

E[(πt − λyt − γf πt+1 − γb πt−1 )zt ] = 0 or E[εt zt ] = 0. (1.11)

Other, more intuitive, way how to obtain the orthogonality conditions

πt = λyt + γf πt+1 + γb πt−1 + υt+1 ,

where υt+1 = −γf ζt+1 .

1.3 Generalized Method of Moments

E[gt (δ)] = E[gt ] = 0 (1.12)

The first equality in (1.12) is there only to remind us that gt is a function

where yt = πt and xt is the L dimensional column vector of regressors.10

E[zt εt ] = E[zt (yt − xt 0 δ)] = E[zt yt ] − E[zt xt 0 ]δ = σZY − ΣZX δ = 0.

where n is the sample size.

δ̂(Ŵ ) ≡ argmin J(δ̃, Ŵ ), (1.13)

It is important to note that GMM is applicable if K ≥ L (so-called order

where S = E[gt gt 0 ] = E[ε2t zt zt 0 ] and the matrix S can be consistently esti-

where Γj is the j-th order autocovariance matrix

Γj = E(gt gt−j 0 ) (j = 0, ±1, ±2, ...).

It is obvious that our previous matrix S containing no serial correlation

ĝt ≡ zt · ε̂t , ε̂t = yt − xt 0 δ̂, and δ̂ is a consistent estimate of δ.

With consistent estimate (1.21) in hand, we can proceed to the consis-

The function k(.) determines the weights assigned to particular autoco-

Regarding the choice of bandwidth, quite a frequent option is nw1 =

If we compute an estimate of the asymptotic variance matrix (1.19) using

1.4 Estimation Results

relatively evenly utilized in literature, we use both of these measures and

1.4.1 Instrumental and Proxy Variables

In this thesis we estimate only (1.5), simply because we do not have

and not the structural ones are estimated, it makes no difference.

In addition, all instrument sets contain a constant (since it is surely un-

1.4.2 Empirical Results

Notes: * denotes 10% significance, denotes 5% significance, * denotes 1%

Notes: * denotes 10% significance, denotes 5% significance, * denotes 1%

Notes: * denotes 10% significance, denotes 5% significance, * denotes 1%

Notes: * denotes 10% significance, denotes 5% significance, * denotes 1%

Notes: * denotes 10% significance, denotes 5% significance, * denotes 1%

Notes: * denotes 10% significance, denotes 5% significance, * denotes 1%

Notes: * denotes 10% significance, denotes 5% significance, * denotes 1%

Notes: * denotes 10% significance, denotes 5% significance, * denotes 1%