DP9611 | Identifying monetary policy in macro-finance models

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Identification problems arise in New Keynesian and macro-finance models when the Taylor rule includes both responses to observable variables like inflation and output, and a shock unseen by economists. Identification of the rule's parameters requires additional restrictions on this unobserved shock. We demonstrate how this can be accomplished in a macro term structure model using only long-run neutrality restrictions consistent with a wide variety of theories. The resulting Taylor rule is comparable to those commonly found in the literature. The unobserved shock is closely related to the slope factor of empirical term structure models.