Title: Fundamental shock selection in DSGE models
Authors: Filippo Ferroni - Banque de France (France)
Stefano Grassi - University of Kent (United Kingdom)
Miguel Leon Ledesma - University of Kent (United Kingdom)
Stefano Grassi - University of Kent (United Kingdom) [presenting]
Abstract: DSGE models are typically estimated assuming the existence of certain structural or fundamental shocks that drive macroeconomic fluctuations. We analyze the consequences of introducing shocks that are non-fundamental for the estimation of DSGE model parameters. We then propose a method to select the structural shocks driving macroeconomic 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 model and find that government, price, and wage markup shocks are non-fundamental.