ISSN 1561081-0
9 771561 081005
WORKING PAPER SERIES
NO 722 / FEBRUARY 2007
SHOCKS AND FRICTIONS
IN US BUSINESS CYCLES
A BAYESIAN
DSGE APPROACH
by Frank Smets
and Rafael Wouters
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WORKING PAPER SERIES
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SHOCKS AND FRICTIONS
IN US BUSINESS CYCLES
A BAYESIAN
DSGE APPROACH
1
by Frank Smets
2
and Rafael Wouters
3
1 We thank seminar participants and discussants at the 2003 ECB/IMOP Workshop on Dynamic Macroeconomics, the Federal Reserve
Board, Princeton University, the Federal Reserve Bank of St.Louis and Chicago, the 2004 AEA meetings in San Diego, University
of Cologne, Humboldt University, the European Central Bank, the Bank of Canada/Swiss National Bank/Federal Reserve Bank of
Cleveland Joint Workshop on Dynamic Models Useful for Policy and in particular Frank Schorfheide, Fabio Canova, Chris Sims, Mark
Gertler and two anonymous referees for very useful and stimulating comments. The views expressed are solely our own and do not
necessarily reflect those of the European Central Bank or the National Bank of Belgium.
2 European Central Bank/CEPR/University of Ghent. Contact address: European Central Bank, Kaiserstrasse 29,
60311 Frankfurt am Main, Germany; e-mail: frank.smets@ecb.int
3 National Bank of Belgium, Boulevard de Berlaimont 14, B-1000 Brussels, Belgium;
e-mail:rafael.wouters@nbb.be
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ISSN 1561-0810 (print)
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Working Paper Series No 722
February 2007
CONTENTS
Abstract
4
Non-technical summary
5
1. Introduction
7
2. The linearized DSGE model
9
3. Parameter estimates
16
3.1 Prior distribution of the parameters
18
3.2 Posterior estimates of the parameters
19
4. Forecast performance: comparison with
VAR models
20
5. Model sensitivity: which frictions are
empirically important?
22
6. Applications
24
6.1 What are the main driving forces
of output?
24
6.2 Determinants of inflation and the
output-inflation cross correlation?
25
6.3 The effect of a productivity shock
on hours worked
27
6.4 The “Great Inflation” and the
“Great Moderation”: sub-sample estimates
28
7. Concluding remarks
30
References
31
Tables and figures
34
Data appendix
47
Model appendix
48
European Central Bank Working Paper Series
54
Abstract
Using a Bayesian likelihood approach, we estimate a dynamic
stochastic general equilibrium model for the US economy using seven
macro-economic time series. The model incorporates many types of
real and nominal frictions and seven types of structural shocks. We
show that this model is able to compete with Bayesian Vector
Autoregression models in out-of-sample prediction. We investigate the
relative empirical importance of the various frictions. Finally, using the
estimated model we address a number of key issues in business cycle
analysis: What are the sources of business cycle fluctuations? Can the
model explain the cross-correlation between output and inflation?
What are the effects of productivity on hours worked? What are the
sources of the “Great Moderation”?
Key words: DSGE models; monetary policy
JEL-classification: E4-E5
4
ECB
Working Paper Series No 722
February 2007
