Validating DSGE Models through Dynamic Factor Models

Mario Forni, Luca Gambetti, Marco Lippi and Luca Sala

No 17379, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: We urge the use of Structural Dynamic Factor Models (DFM) to validate and to guide the construction of Dynamic Stochastic General Equilibrium (DSGE) models. The main reason is that the log-linear solution of a DSGE model has a factor structure which ensures consistency between the representations of the two models. We assess, by means of a few simulations, the validity of SDFM as an empirical tool to complement DSGE analysis. Using a DSGE model as data generating process, the factor model provides very accurate estimates of the true impulse response functions. As an application, we validate a theory of TFP news and surprise shocks.

Date: 2022-06
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