An estimated dynamic stochastic general equilibrium model of the euro area

TLDR: In this paper, a dynamic stochastic general equilibrium (DSGE) model with sticky prices and wages for the euro area was developed and estimated with Bayesian techniques using seven key macroeconomic variables: GDP, consumption, investment, prices, real wages, employment, and the nominal interest rate.

Abstract: This paper develops and estimates a dynamic stochastic general equilibrium (DSGE) model with sticky prices and wages for the euro area. The model incorporates various other features such as habit formation, costs of adjustment in capital accumulation and variable capacity utilization. It is estimated with Bayesian techniques using seven key macroeconomic variables: GDP, consumption, investment, prices, real wages, employment, and the nominal interest rate. The introduction of ten orthogonal structural shocks (including productivity, labor supply, investment, preference, cost-push, and monetary policy shocks) allows for an empirical investigation of the effects of such shocks and of their contribution to business cycle e uctuations in the euro area. Using the estimated model, we also analyze the output (real interest rate) gap, dee ned as the difference between the actual and model-based potential output (real interest rate). (JEL: E4, E5)

Figures

Table 3: Variance decomposition

Table 2: Estimation statistics

Table 1: Parameter estimates

Full text

Smets, Frank; Wouters, Raf
Working Paper
An estimated dynamic stochastic general equilibrium
model of the euro area
NBB Working Paper, No. 35
Provided in Cooperation with:
National Bank of Belgium, Brussels
Suggested Citation: Smets, Frank; Wouters, Raf (2002) : An estimated dynamic stochastic
general equilibrium model of the euro area, NBB Working Paper, No. 35, National Bank of
Belgium, Brussels
This Version is available at:
http://hdl.handle.net/10419/144249
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NBB WORKING PAPER No. 35 - October 2002 1
NATIONAL BANK OF BELGIUM
WORKING PAPERS - RESEARCH SERIES
AN ESTIMATED DYNAMIC STOCHASTIC GENERAL EQUILIBRIUM MODEL
OF THE EURO AREA
_______________________________
Frank Smets
(*)
& Raf Wouters
(**)
We thank participants in the ECB Workshop on “DSGE models and their use in monetary
policy”, the San Francisco Fed/SIEPR Conference on “Macroeconomic models for
monetary policy” and the NBER/EEA International Seminar on Macroeconomics (ISOM)
and in particular our discussants, Harris Dellas, Stefano Siviero, Peter Ireland, Lars
Svensson, Jordi Gali and Noah Williams for very useful comments. We thank Larry
Christiano, Chris Sims, Fabio Canova and Frank Schorfheide for very insightful
discussions. We are also grateful to Frank Schorfheide for making his code available.
Finally, thanks are also due to Jim Stock (editor) and three anonymous referees of the
Journal of the European Economic Association. A previous version of the paper was
published at the occasion of the ISOM-conference as ECB-WP No. 171. The views
expressed are solely our own and do not necessarily reflect those of the European Central
Bank or the National Bank of Belgium. All remaining errors are the author’s.
(*)
Frank Smets: European Central Bank and CEPR, e-mail: Frank.Smets@ecb.int.
(**)
NBB, Research Department, (e-mail: Rafael.Wouters@nbb.be).

2 NBB WORKING PAPER No.35 - October 2002
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ISSN: 1375-680X

NBB WORKING PAPER No. 35 - October 2002 1
Abstract
This paper develops and estimates a dynamic stochastic general equilibrium
(DSGE) model with sticky prices and wages for the euro area. The model incorporates
various other features such as habit formation, costs of adjustment in capital accumulation
and variable capacity utilisation. It is estimated with Bayesian techniques using seven key
macro-economic variables: GDP, consumption, investment, prices, real wages,
employment and the nominal interest rate. The introduction of ten orthogonal structural
shocks (including productivity, labour supply, investment, preference, cost-push and
monetary policy shocks) allows for an empirical investigation of the effects of such shocks
and of their contribution to business cycle fluctuations in the euro area. Using the
estimated model, the paper also analyses the output (real interest rate) gap, defined as the
difference between the actual and model-based potential output (real interest rate).
Key words: DSGE models; monetary policy; euro area
JEL-classification: E4-E5

2 NBB WORKING PAPER No.35 - October 2002

Frequently asked questions

Q1. What are the contributions in "An estimated dynamic stochastic general equilibrium model of the euro area" ?

In this paper, the authors present and estimate a stochastic dynamic general equilibrium ( DSGE ) model for the euro area. 

Q2. What is the effect of a positive preference shock on investment?

Graph 7 shows that a positive preference shock, while increasing consumption and output significantly, has a significant negative crowding-out effect on investment. 

Q3. What is the argument that monetary authorities should not accommodate such variations?

As these shocks give rise to inefficient variations in the flexible-price-and-wage level of output, one can argue that monetary authorities should not accommodate such variations and instead try to keep output at its efficient level. 

Q4. What are the parameters that can be estimated from the mean of the observable variables?

Most of these parameters can be directly related to the steady-state values of the state variables and could therefore be estimated from the means of the observable variables (or linear combinations of them). 

Q5. What is the degree of stickiness of the price and wage curves?

Only when they assume decreasing returns to scale and an upward-sloping marginal cost curve, Gali, Gertler and LopezSalido (2000) estimate a more reasonable degree of price stickiness that is comparable with what the authors estimate for wages.