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Frequentist Evaluation of Small DSGE Models

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  • Gunnar BÃ¥rdsen
  • Luca Fanelli

Abstract

This article proposes a new evaluation approach for the class of small-scale "hybrid" new Keynesian dynamic stochastic general equilibrium (NK-DSGE) models typically used in monetary policy and business cycle analysis. The empirical assessment of the NK-DSGE model is based on a conditional sequence of likelihood-based tests conducted in a vector autoregressive (VAR) system, in which both the low- and high-frequency implications of the model are addressed in a coherent framework. If the low-frequency behavior of the original time series of the model can be approximated by nonstationary processes, stationarity must be imposed by removing the stochastic trends. This gives rise to a set of recoverable unit roots/cointegration restrictions, in addition to the short-run cross-equation restrictions. The procedure is based on the sequence "LR1→LR2→LR3," where LR1 is the cointegration rank test, LR2 is the cointegration matrix test, and LR3 is the cross-equation restrictions test: LR2 is computed conditional on LR1 and LR3 is computed conditional on LR2. The Type I errors of the three tests are set consistently with a prefixed overall nominal significance level. A bootstrap analog of the testing strategy is proposed in small samples. We show that the information stemming from the individual tests can be used constructively to uncover which features of the data are not captured by the theoretical model and thus to rectify, when possible, the specification. We investigate the empirical size properties of the proposed testing strategy by a Monte Carlo experiment and show the empirical usefulness of our approach by estimating and testing a monetary business cycle NK-DSGE model using U.S. quarterly data. Supplementary materials for this article are available online.

Suggested Citation

  • Gunnar BÃ¥rdsen & Luca Fanelli, 2015. "Frequentist Evaluation of Small DSGE Models," Journal of Business & Economic Statistics, Taylor & Francis Journals, vol. 33(3), pages 307-322, July.
  • Handle: RePEc:taf:jnlbes:v:33:y:2015:i:3:p:307-322 DOI: 10.1080/07350015.2014.948724
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    Cited by:

    1. Morris, Stephen D., 2017. "DSGE pileups," Journal of Economic Dynamics and Control, Elsevier, vol. 74(C), pages 56-86.

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    JEL classification:

    • C5 - Mathematical and Quantitative Methods - - Econometric Modeling
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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