Forecasting and Policy Making (Paper) - Center for Financial Studies

shows shocks to the potential output growth rate. A series of highly negative shocks led to the current
extremely low estimates of potential output growth. Given the high variance of this shock series po-
tential output could quickly adjust back to higher equilibrium growth rates once actual output growth
increases.
5.4 Forecasting with medium-scale New-Keynesian DSGE models
In recent years many policy institution have built medium-size dynamic stochastic general equilib-
rium (DSGE) models that offer much more detailed structural interpretations of the data as the small
model of the preceding section. More and more of these DSGE models are also used as a tool in the
forecasting process. For example, the European Central Bank has replaced its earlier, more traditional
Area-Wide Model of Fagan et al. (2005) which featured largely backward-looking dynamics, with
a New-Area-Wide Model (see Christoffel et al. (2008)) of the DSGE variety in the ECB staff forecasting
process. 31 The Federal Reserve makes use of the FRB/EDO model of Edge et al. (2008), 32
though the FRB-US model still remains its principal model for policy analysis. DSGE models used
at other central banks include the ToTEM model of the Bank of Cananda (Murchison and Rennison,
2006; Fenton and Murchison, 2006) and the Ramses model used at the Swedish Riksbank (Adolfson
et al., 2007b, 2008). All these models build on the medium-size DSGE model of Christiano et al.
(2005). Christiano et al extended the simple New-Keynesian DSGE model and showed that such a
medium-size DSGE model can match the VAR-based estimate of a monetary impulse response func-
tion. Typically, these models are estimated instead with Bayesian estimation methods as proposed and
exemplified by Smets and Wouters (2003, 2007). In this manner they are able to explain the dynamics
of a large number of macroeconomic times series.
In the following, we will produce and interpret forecasts using such a medium-scale DSGE model
estimated in Cogan et al. (2010). Cogan et al. extended the Smets and Wouters (2007) model of the
U.S. economy by introducing a share of households that consume current income. Such an extension
was proposed by Gali and Lopez-Salido (2007) in the context of a small New Keynesian model in
order to understand the consequences of fiscal shocks. Cogan et al. (2010) use this model to analyze
the interaction of monetary policy and the U.S. ARRA fiscal stimulus at interest rates near the zero-
lower bound. In the following, we refer to this model as the CCTW-SW model.
An appealing feature of DSGE models is that they implement all restrictions arising from
optimizing behavior of households and firms subject to clearly specified constraints. Thereby they
go far in the Lucas critique and offer a useful input for monetary policy making. DSGE models are
31 In addition, the model of Christiano et al. (2008), which includes a more detailed financial sector also plays an important
role. The use of both models at the ECB is described in Smets et al. (2010)
32 The FRB-EDO features two production sectors, which differ with respect to the pace of technological progress. This
structure can capture the different growth rates and relative prices observed in the data. Accordingly, the expenditure side is
disaggregated as well. It is divided into business investment and three categories of household expenditure: consumption of
non-durables and services, investment in durable goods and residential investment. The model is able to capture different
cyclical properties in these four expenditure categories. The model is estimated using Bayesian techniques on eleven time
series.
46