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    The role of theory in econometrics

    Pesaran, M.H. and Smith, Ron P. (1995) The role of theory in econometrics. Journal of Econometrics 67 (1), pp. 61-79. ISSN 0304-4076.

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    This paper discusses the way that theory is used in applied econometrics. The traditional strategy of marrying theory and evidence relied on the fact that older theory implied explicit restrictions on the conditional distribution of observable variables and could be evaluated in terms of the conditional predictions of the model embodying the theoretical restrictions. However, this is not true of newer theories based on dynamic stochastic optimisation of models which are not based on quadratic objective functions and linear constraints; the so-called ‘LQ form’. Because these models do not usually have closed-form solutions, they tend to be calibrated rather than estimated and cannot be readily evaluated in terms of their conditional predictions. The application of the stochastic version of the Maximum Principle to such models results in Lagrange multipliers, often shadow prices corresponding to missing markets, which are not observed by the econometrician. Just as agents condition their decisions on unobserved expected prices when forward markets do not exist, they also condition on unobserved shadow prices when particular current or contingent markets do not exist. The approach suggested in this paper is to substitute out the Lagrange multipliers in terms of their determinants, just as is often done with expectations. The approach is illustrated in some detail for two examples: consumer behaviour under liquidity constraints, and oil production.


    Item Type: Article
    School: School of Business, Economics & Informatics > Economics, Mathematics and Statistics
    Depositing User: Sarah Hall
    Date Deposited: 03 Nov 2020 20:24
    Last Modified: 01 Dec 2021 16:28


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