On the Fit and Forecasting Performance of New Keynesian Models

Marco Del Negro, Frank Schorfheide, Frank Smets, and Raf Wouters
Working Paper 2004-37
December 2004

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The paper provides new tools for the evaluation of DSGE models and applies them to a large-scale New Keynesian dynamic stochastic general equilibrium (DSGE) model with price and wage stickiness and capital accumulation. Specifically, we approximate the DSGE model by a vector autoregression (VAR) and then systematically relax the implied cross-equation restrictions. Let denote the extent to which the restrictions are being relaxed. We document how the in- and out-of-sample fit of the resulting specification (DSGE-VAR) changes as a function of . Furthermore, we learn about the precise nature of the misspecification by comparing the DSGE model’s impulse responses to structural shocks with those of the best-fitting DSGE-VAR. We find that the degree of misspecification in large-scale DSGE models is no longer so large as to prevent their use in day-to-day policy analysis, yet it is not small enough that it cannot be ignored.

JEL classification: C11, C32, C53

Key words: Bayesian analysis, DSGE models, model evaluation, vector autoregressions

We thank seminar participants at the Atlanta Fed, New York University, Northwestern University, the Richmond Fed, the University of Virginia, Stanford University, Yale University, the workshop at the Cleveland Fed on empirical methods and applications to DSGE models, the 2nd Euro Area Business Cycle Network (ECB, Fall 2003), 2004 SED, and 2004 SCE conferences for useful comments. The views expressed in this papers are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta, the Federal Reserve System, the European Central Bank, or the National Bank of Belgium. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to Marco Del Negro, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309, 404-498-8561, marco.delnegro@atl.frb.org; Frank Schorfheide, University of Pennsylvania and NYU, schorf@ssc.upenn.edu; Frank Smets, European Central Bank and CEPR, frank.smets@ecb.int; or Raf Wouters, National Bank of Belgium, rafael.wouters@nbb.be.