Fundamental shock selection in DSGE models

Filippo Ferroni, Stefano Grassi () and Miguel Leon-Ledesma

Studies in Economics from School of Economics, University of Kent

Abstract: DSGE models are typically estimated assuming the existence of certain structural shocks that drive macroeconomic fluctuations. We analyze the consequences of introducing nonfundamental shocks for the estimation of DSGE model parameters and propose a method to select the structural shocks driving uncertainty. We show that forcing the existence of non-fundamental structural shocks produces a downward bias in the estimated internal persistence of the model. We then show how these distortions can be reduced by allowing the covariance matrix of the structural shocks to be rank deficient using priors for standard deviations whose support includes zero. The method allows us to accurately select fundamental shocks and estimate model parameters with precision. Finally, we revisit the empirical evidence on an industry standard medium-scale DSGE model and find that government, price, and wage markup shocks are non-fundamental.

Keywords: Reduced rank covariance matrix; DSGE models; stochastic dimension search (search for similar items in EconPapers)
JEL-codes: C10 E27 E32 (search for similar items in EconPapers)
Date: 2015-05
New Economics Papers: this item is included in nep-dge, nep-ecm and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (9)

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Working Paper: Fundamental shock selection in DSGE models (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:ukc:ukcedp:1508

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