Ensuring the Validity of the Micro Foundation in DSGE Models

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Ensuring the Validity of the Micro Foundation in DSGE Models

Author Info

Martin Møller Andreasen () (School of Economics and Management, University of Aarhus, Denmark and CREATES)

Abstract

The presence of i) stochastic trends, ii) deterministic trends, and/or iii) stochastic volatil- ity in DSGE models may imply that the agents' objective functions attain infinite values. We say that such models do not have a valid micro foundation. The paper derives sufficient condi- tions which ensure that the objective functions of the households and the firms are finite even when various trends and stochastic volatility are included in a standard DSGE model. Based on these conditions we test the validity of the micro foundation in six DSGE models from the literature. The models of Justiniano & Primiceri (American Economic Review, forth- coming) and Fernández-Villaverde & Rubio-Ramírez (Review of Economic Studies, 2007) do not satisfy these sufficient conditions, or any other known set of conditions ensuring finite values for the objective functions. Thus, the validity of the micro foundation in these models remains to be established.

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Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2008-26.

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Length: 43
Date of creation: 26 May 2008
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Handle: RePEc:aah:create:2008-26

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Find related papers by JEL classification:
E10 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - General
E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)

This paper has been announced in the following NEP Reports:

NEP-ALL-2008-06-27 (All new papers)
NEP-CBA-2008-06-27 (Central Banking)
NEP-DGE-2008-06-27 (Dynamic General Equilibrium)
NEP-ECM-2008-06-27 (Econometrics)
NEP-ETS-2008-06-27 (Econometric Time Series)
NEP-MAC-2008-06-27 (Macroeconomics)

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