On the Identification of Diagnostic Expectations: Econometric Insights from DSGE Models

Abstract

This paper shows that diagnostic expectations (DE) and rational expectations (RE) are not observationally equivalent in dynamic stochastic general equilibrium (DSGE) models. Using the frequency-domain framework of Qu and Tkachenko (2012, 2017), I show that no RE parameterization yields the DE-implied autocovariance structure of the macroeconomic observables considered in either small- or medium-scale DSGE models, even after structural frictions and shock processes are reparameterized. Incorporating DE preserves overall identification but weakens the identification of shock variances. In the medium-scale model, among the frictions, wage rigidity emerges as most important for generating the benchmark DE model dynamics.