An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area

The paper develops and estimates a stochastic dynamic general equilibrium model of the euro area in which prices and wages are both set in staggered Calvo contracts with partial indexation to past inflation, consumption is subject to external habit formation, capital utilisation is variable with a utilisation cost expressed in consumption goods, and capital adjustment costs are a function of the change in investment rather than its level – a structure assembled from Christiano, Eichenbaum and Evans (2001), Kollmann (1997), Erceg, Henderson and Levin (2000), Greenwood, Hercowitz and Huffman (1988) and King and Rebelo (2000). What distinguishes it from that lineage is the estimation: ten orthogonal structural shocks (two supply, three demand, three cost-push and two monetary policy) are introduced so that the model can be confronted with seven euro area macroeconomic series – real GDP, consumption, investment, the GDP deflator, real wages, employment and the nominal short-term interest rate – over 1970:1-1999:4, with the likelihood computed by the Kalman filter and the posterior explored by a Metropolis-Hastings algorithm. Because euro area hours worked are unavailable, employment enters instead, with only a fixed fraction of firms able to adjust employment each period and unobserved hours per employee absorbing the remainder. A small set of parameters is fixed rather than estimated – the discount factor at 0.99 (a 4 percent annual steady-state real rate), quarterly depreciation at 0.025, the capital share at 0.3, consumption and investment shares of output at 0.6 and 0.22, and the wage mark-up parameter at 0.5 because it is not identified – leaving 34 estimated parameters. On marginal likelihood the estimated model beats standard VARs of lag order one to three and is nearly matched by the best Bayesian VAR with a Minnesota prior, the BVAR(3), over 1980:2-1999:4. The parameter estimates imply considerable nominal stickiness, with average price contract duration of about two and a half years against about one year for wages – an ordering the authors call counterintuitive but robust, and attribute partly to their assumption of a flat marginal cost curve in the intermediate goods sector. Price indexation is estimated at 0.4, implying a weight on lagged inflation of only 0.28; external habit is about 55 percent of past consumption; the labour supply elasticity is estimated to be relatively high but imprecisely; and the estimated policy rule satisfies the Taylor principle with substantial interest rate smoothing. In the variance decomposition, three shocks – preference, labour supply and monetary policy – explain significant fractions of output, inflation and interest rates at medium to long horizons, with the price mark-up shock important for inflation but not output and productivity accounting for at most about 12 percent of output forecast error variance. Using the model to construct potential output, defined as the flexible-price-and-wage level in the absence of mark-up shocks, the authors obtain a path very different from a smoothed output trend, with a sharp fall in potential from 1973 to 1975; but they emphasise that the confidence bands are wide, and that the real interest rate gap “is hardly significant over the sample period,” suggesting it “may be a poor guide for monetary policy.”

Raf Wouters | Macro Paper Warehouse

An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area