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

1. IntroductionIn this paper we present and estimate a stochastic dynamic general equilibrium (DSGE) model forthe euro area. Following Christiano, Eichenbaum and Evans (CEE, 2001) the model features anumber of frictions that appear to be necessary to capture the empirical persistence in the main euroarea macro-economic data. Many of these frictions have become quite standard in the DSGEliterature. Following Kollmann (1997) and Erceg, Henderson and Levin (2000), the model exhibitsboth sticky nominal prices and wages that adjust following a Calvo mechanism. However, theintroduction of partial indexation of the prices and wages that can not be re-optimised results in amore general dynamic inflation and wage specification that will also depend on past inflation.Following Greenwood, Hercowitz, and Huffmann (1988) and King and Rebelo (2000) the modelincorporates a variable capital utilisation rate. This tends to smooth the adjustment of the rental rateof capital in response to changes in output. As in CEE (2001), the cost of adjusting the utilisationrate is expressed in terms of consumption goods. We also follow CEE (2001) by modelling the costof adjusting the capital stock as a function of the change in investment, rather than the level ofinvestment as is commonly done. Finally, external habit formation in consumption is used tointroduce the necessary empirical persistence in the consumption process (See Fuhrer (2000) andMcCallum and Nelson (1999)).While the model used in this paper has many elements in common with that used in CEE (2001),the analysis differs in two main respects: the number of structural shocks that are introduced and themethodology for estimating the DSGE model. We introduce a full set of structural shocks to thevarious structural equations. 1 Next to five shocks arising from technology and preferences (aproductivity shock, a labour supply shock, a shock to the household’s discount factor, a shock to theinvestment adjustment cost function, and a government consumption shock), we add three “costpush”shocks (modelled as shocks to the mark-up in the goods and labour markets and a shock tothe required risk premium on capital) and two monetary policy shocks. We estimate the parametersof the model and the stochastic processes governing the structural shocks using seven key macroeconomictime series in the euro area: real GDP, consumption, investment, the GDP deflator, thereal wage, employment and the nominal short-term interest rate. Following recent developments inBayesian estimation techniques (see, e.g., Geweke (1999) and Schorfheide (2002)), we estimate themodel by maximising over the posterior distribution of the model parameters based on thelinearised state-space representation of the DSGE model. The purpose of the estimation in thispaper is twofold. First, it allows us to evaluate the ability of the new generation of New-Keynesian1CEE (2001) only consider the effects of a monetary policy shock. They estimate a subset of the structural parametersusing indirect inference methods by minimising the distance between the estimated impulse responses of a monetarypolicy shock in an identified VAR and those based on the DSGE model. There are also small differences in the modelspecification. For example, we generalise the indexation mechanism in goods and labour markets to allow for partialindexation. This allows us to estimate the degree of “backward-looking-ness” in the inflation and wage equation. Onthe other hand, our model does not include an interest rate cost channel.NBB WORKING PAPER No. 35 - October 2002 1