Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/129996
Authors: 
Ferroni, Filippo
Grassi, Stefano
León-Ledesma, Miguel A.
Year of Publication: 
2015
Series/Report no.: 
School of Economics Discussion Papers 1508
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.
Subjects: 
reduced rank covariance matrix
DSGE models
stochastic dimension search
JEL: 
C10
E27
E32
Document Type: 
Working Paper

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