Infinite-dimensional dynamic factor model for the integration of international factors into small open economy DSGE models

This paper addresses the challenge of empirically identifying and integrating the international sector within small open economy DSGE models. While theoretical structures have been developed to model international dynamics, effective methods for bringing this aspect of the model closer to real-world data remain scarce. This study proposes a solution by employing a Structural Dynamic Factor Model (DFM) approach, utilizing an infinite-dimensional generalized dynamic factor representation to estimate rest-of-the-world time series. These series are subsequently incorporated into a DSGE model calibrated for the Italian economy, enabling a more realistic modeling of external shocks and their transmission mechanisms. The methodology also involves deriving impulse response functions (IRFs) from both the theoretical DSGE and the empirically estimated DFM, providing a rigorous validation framework. The results demonstrate the potential of this approach to enhance the specification of Italy's international sector, leveraging the advantages of fundamentalness and robustness inherent in the DFM methodology