An estimated dynamic stochastic general equilibrium model of the ...

price and wages in the absence of the three “cost-push” shocks. 18 The parameter ρ captures thedegree of interest rate smoothing. In addition, there is also a short-run feedback from the currentchanges in inflation and the output gap. Finally, we assume that there are two monetary policyshocks: one is a persistent shock to the inflation objective ( π t ) which is assumed to follow a firstorderautoregressive process ( π t = ρππt−1 + ηt); the other is a temporary IID-Normal interestπRrate shock ( η t ). The latter will also be denoted a monetary policy shock. Of course, it is importantto realise that there was no single monetary authority during most of the sample period that we willuse in estimating equation (36). However, Gerlach and Schnabel (2000) have shown that since theearly 1990s average interest rates in the euro area can be characterised quite well by a Taylor rule.This is in line with the findings of Clarida, Gali and Gertler (1998) that a Taylor-type monetarypolicy reaction function is able to describe the behaviour of both the Bundesbank, which acted asthe de facto anchor of the European exchange rate mechanism, and the French and Italian centralbanks since the early 1980s.Equations (28) to (36) determine the nine endogenous variables: πˆ t ,krˆ t ,ŵ t ,Kˆ t , Qˆ t, Î t ,Lˆt of our model. The stochastic behaviour of the system of linear rational expectationsequations is driven by ten exogenous shock variables: five shocks arising from technology anda I B L Gw p Qpreferences ( ε t , ε t , ε t , ε t , ε t ), three “cost-push” shocks ( η t , η t and η t ) and twoRmonetary policy shocks ( π t and η t ). As discussed above, the first set of shock variables areassumed to follow an independent first-order autoregressive stochastic process, whereas the secondset are assumed to be IID independent processes.Ĉ t ,Rˆt ,3 Estimation resultsIn this section we, first, discuss how we estimate the structural parameters and the processesgoverning the ten structural shocks. Next, we present the main estimation results. Finally, wecompare the empirical performance of the estimated DSGE model with a number of a-theoreticalVARs.3.1 Estimation methodologyThere are various ways of estimating or calibrating the parameters of a linearised DSGE model.Geweke (1999) distinguishes between the weak and the strong econometric interpretation of DSGEmodels. The weak interpretation is closest in spirit to the original RBC programme developed byKydland and Prescott (1982). 19 The parameters of a DSGE model are calibrated in such a way that1819See Section 5 for a discussion of this output gap concept. In practical terms, we expand the model consisting ofequations (28) to (36) with a flexible-price-and-wage version in order to calculate the model-consistent output gap.It is in line with Kydland and Prescott’s (1996) emphasis on the fact that the model economy is intended to “mimic theworld along a carefully specified set of dimensions”.14 NBB WORKING PAPER No.35 - October 2002