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Stochastic Dynamic Macroeconomics - Theory, Numerics and Empirical Evidence - Gong and Semmler 2004

Stochastic Dynamic Macroeconomics - Theory, Numerics and Empirical Evidence - Gong and Semmler 2004

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6.3.1 The Structural Parameters to be Estimated

The RBC model presented in section 2 contains seven parameters, α,δ,r,g,γ,

φ, and N. Recall that the discount factor is determined in (6.3) for given

values of g,r and γ. The parameter θ is simply dropped due to our log-linear

approximation. Of course, we would like to estimate as many parameters

as possible. However, some of the parameters have to be pre-specified. The

computation of technology shocks requires the values for α and g. In this

paper we use the standard values of α = 0.667 and g = 0.005. N is specified

as 0.3. The parameter φ is estimated independently from (6.4) by OLS

regression. This leaves the risk aversion parameter γ, the average interest

rate r and the depreciation rate δ to be estimated. The estimation strategy is

similar to Christiano and Eichenbaum (1992). However, they fix the discount

factor and the risk aversion parameter without estimating them. In contrast,

the estimation of these parameters is central to our strategy, as we will see

shortly.

6.3.2 The Data

For the real variables of the economy, we use the data set as constructed by

Christiano (1987). The data set covers the period from the third quarter

of 1955 through the fourth quarter of 1983 (1955.1-1983.4). As we have

demonstrated in the last chapter, the Christiano data set can match the real

side of the economy better than the commonly used NIPA data set. For

the time series of the risk-free interest rate, we use the 30-day T-bill rate to

minimize unmodeled inflation risk.

To make the data suitable for estimation, we are required to detrend the

data into their log-deviation form. For a data observation Xt, the detrended

value xt is assumed to take the form log( Xt/Xt), where Xt is the value

of Xt on its steady state path, i.e., Xt = (1 + g)t−1

X1. Therefore, for the

given g, which could be calculated from the sample, the computation of

xt depends on X1, the initial Xt. We compute this initial condition based on

108

the consideration that the mean of xt is equal to 0. In other words,

1

T

T
i=1

log(Xt/Xt) = 1
T

T
i=1

log(Xt)− 1
T

T
i=1

log(Xt)

= 1

T

T
i=1

log(Xt)− 1
T

T
i=1

log(X1)− 1
T

T
i=1

log

(1 + g)t−1

= 0

Solving the above equation for X1, we obtain

X1 = 1

T exp

T
i=1

log(Xt)−

T
i=1

log

(1 + g)t−1

.

6.3.3 The Moment Restrictions of Estimation

For the estimation in this chapter, we use the maximum likelihood (ML)

method as discussed in Chapter 3. In order to analyze the role of each

restriction, we introduce the restrictions step-by-step. First, we constrain

the risk aversion parameter r to unity and use only moment restrictions of

the real variables, i.e. (6.5) - (6.7) so we can compare our results to those

in Christiano and Eichenbaum (1992). The remaining parameters thus to be

estimated are δ and r. We call this Model 1 (M1). The matrices for the ML

estimation are given by

B =

1 0 0

ηck 1 0

ηck 0 1

, Γ =

ηkk −ηka 0

0 0 −ηca

0 0 −ηna

,

yt =

kt

ct

nt

, xt =

kt−1

at−1

at

.

After considering the estimation with the moment restrictions only for real

variables, we add restrictions from asset markets one by one. We start by

including the following moment restriction of the risk-free interest rate in

estimation while still keeping risk aversion fixed at unity:

E

bt−rf
t

= 0

109

where bt denotes the return on the 30-day T-bill and the risk-free rate rf

t is
computed as in (6.9). We refer to this version as Model 2 (M2). In this case

the matrices B and Γ and the vectors xt and yt can be written as

B =

1 0 0 0

ηnk 1 0 0

ηnk 0 1 0

0 0 0 1

, Γ =

ηkk −ηka 0 0

0 0 −ηca 0

0 0 −ηna 0

0 0 0 −1

,

yt =

kt

ct

nt

bt

, xt =

kt−1

at−1

at

rf
t

.

Model 3 (M3) uses the same moment restrictions as Model 2 but leaves the

risk aversion parameter r to be estimated rather than fixed to unity.

Finally, we impose that the dynamic model should generate a Sharpe-ratio

of 0.27 as measured in the data (see Table 1). We take this restriction into

account in two different ways. First, as a shortcut, we fix the risk aversion

at 50, a value suggested in Lettau and Uhlig (1999) for generating a Sharpe-

ratio of 0.27 using actual consumption data. Given this value, we estimate the

remaining parameter δ and r. This will be called Model 4 (M4). In the next

version, Model 5 (M5), we are simultaneously estimating γ while imposing

a Sharpe-ratio restriction of 0.27. Recall from (6.11) that the Sharpe-ratio

is a function of risk aversion, the standard deviation of the technology shock

and the elasticity of consumption with respect to the shock ηca. Of course,

ηca is itself a complicated function of γ. Hence, the Sharpe-ratio restriction

becomes

γ = 0.27
ηca(γ)σε

.

(6.14)

This equation provides the solution of γ, given the other parameters δ

and r. Since it is nonlinear in γ, we, therefore, have to use an iterative

procedure to obtain the solution. For each given δ and r, searched by the

simulated annealing, we first set an initial γ, denoted by γ0. Then the new γ,

denoted by γ1, is calculated from (6.14), which is equal to 0.27/[ηca(γ0)σε].

This procedure is continued until convergence.

We summarize the different cases in Table 6.2, where we start by using

only restrictions on real variables and fix risk aversion to unity (M1). We add

the risk-free rate restriction keeping risk aversion at one (M2), then estimate

110

it (M3). Finally we add the Sharpe-ratio restriction, fixing risk aversion at 50

(M4) and estimate it using an iterative procedure (M5). For each model we

also compute the implied values of the long-term bond and equity premium

using (6.12) and (6.13).

Table 6.2: Summary of Models

Models Estimated Parameters Fixed Parameters Asset Restrictions

M1

r,δ

γ = 1

none

M2

r,δ

γ = 1

risk-free rate

M3

r,δ,γ

risk-free rate

M4

r,δ

γ = 50

risk-free rate, Sharpe-ratio

M5

r,δ,γ

risk-free rate, Sharpe-ratio

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