Testing Steady-State Restrictions of Linear Rational Expectations Models when Data are Highly Persistent*

Abstract

Steady-state restrictions are commonly imposed on highly persistent variables to achieve stationarity prior to confronting rational expectations models with data. However, the resulting steady-state deviations are often surprisingly persistent indicating that some aspects of the underlying theory may be empirically problematic. This paper discusses how to formulate steady-state restrictions in rational expectations models with latent forcing variables and test their validity using cointegration techniques. The approach is illustrated by testing steady-state restrictions for alternative specifications of the New Keynesian model and shown to be able to discriminate between different assumptions on the sources of the permanent shocks.

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