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Copyright © Taylor & Francis Group, LLC
ISSN: 07474938 print/15324168 online
DOI: 10.1080/07474930701220071
BAYESIAN ANALYSIS OF DSGE MODELS
Sungbae An School of Economics and Social Sciences, Singapore Management
University, Singapore
Frank Schorfheide Department of Economics, University of Pennsylvania,
Philadelphia, Pennsylvania, USA
This paper reviews Bayesian methods that have been developed in recent years to estimate
and evaluate dynamic stochastic general equilibrium (DSGE) models. We consider the estimation
of linearized DSGE models, the evaluation of models based on Bayesian model checking,
posterior odds comparisons, and comparisons to vector autoregressions, as well as the nonlinear
estimation based on a secondorder accurate model solution. These methods are applied to data
generated from correctly speciﬁed and misspeciﬁed linearized DSGE models and a DSGE model
that was solved with a secondorder perturbation method.
Keywords Bayesian analysis; DSGE models; Model evaluation; Vector autoregressions.
JEL Classiﬁcation C11; C32; C51; C52.
1. INTRODUCTION
Dynamic stochastic general equilibrium (DSGE) models are micro
founded optimizationbased models that have become very popular in
macroeconomics over the past 25 years. They are taught in virtually
every Ph.D. program and represent a signiﬁcant share of publications in
macroeconomics. For a long time the quantitative evaluation of DSGE
models was conducted without formal statistical methods. While DSGE
models provide a complete multivariate stochastic process representation
for the data, simple models impose very strong restrictions on actual time
series and are in many cases rejected against less restrictive speciﬁcations
such as vector autoregressions (VAR). Apparent model misspeciﬁcations
were used as an argument in favor of informal calibration approaches
along the lines of Kydland and Prescott (1982).
Received August 20, 2005; Accepted July 15, 2006
Address correspondence to Frank Schorfheide, Department of Economics, University of
Pennsylvania, 3718 Locust Walk, Philadelphia, PA 19104, USA; Email: schorf@ssc.upenn.edu
114 S. An and F. Schorfheide
Subsequently, many authors have developed econometric frameworks
that formalize aspects of the calibration approach by taking model
misspeciﬁcation explicitly into account. Examples are Smith (1993),
Watson (1993), Canova (1994), DeJong et al. (1996), Diebold et al.
(1998), Geweke (1999b), Schorfheide (2000), Dridi et al. (2007), and
Bierens (2007). At the same time, macroeconomists have improved the
structural models and relaxed many of the misspeciﬁed restrictions of
the ﬁrst generation of DSGE models. As a consequence, more traditional
econometric techniques have become applicable. The most recent vintage
of DSGE models is not just attractive from a theoretical perspective but
is also emerging as a useful tool for forecasting and quantitative policy
analysis in macroeconomics. Moreover, owing to improved time series ﬁt
these models are gaining credibility in policymaking institutions such as
central banks.
This paper reviews Bayesian estimation and evaluation techniques
that have been developed in recent years for empirical work with DSGE
models.
1
We focus on methods that are built around a likelihood function
derived from the DSGE model. The econometric analysis has to cope
with several challenges, including potential model misspeciﬁcation and
identiﬁcation problems. We will illustrate how a Bayesian framework can
address these challenges. Most of the techniques described in this article
have been developed and applied in other papers. Our contribution is
to give a uniﬁed perspective, by applying these methods successively to
artiﬁcial data generated from a DSGE model and a VAR. We provide some
evidence on the performance of Markov Chain Monte Carlo (MCMC)
methods that have been applied to the Bayesian estimation of DSGE
models. Moreover, we present new results on the use of ﬁrstorder accurate
versus secondorder accurate solutions in the estimation of DSGE models.
The paper is structured as follows. Section 2 outlines two versions of
a ﬁveequation New Keynesian DSGE model along the lines of Woodford
(2003) that differ with respect to the monetary policy rule. This model
serves as the foundation for the current generation of largescale models
that are used for the analysis of monetary policy in academic and central
bank circles. Section 3 discusses some preliminaries, in particular the
challenges that have to be confronted by the econometric framework.
We proceed by generating several data sets that are used subsequently
for model estimation and evaluation. We simulate samples from the ﬁrst
order accurate solution of the DSGE model presented in Section 2,
from a modiﬁed version of the DSGE model in order to introduce
1
There is also an extensive literature on classical estimation and evaluation of DSGE models,
but a detailed survey of these methods is beyond the scope of this article. The interested reader is
referred to Kim and Pagan (1995) and the book by Canova (2007), which discusses both classical
and Bayesian methods for the analysis of DSGE models.
Bayesian Analysis of DSGE Models 115
misspeciﬁcation, and from the secondorder accurate solution of the
benchmark DSGE model.
Owing to the computational burden associated with the likelihood
evaluation for nonlinear solutions of the DSGE model, most of the
empirical literature has estimated linearized DSGE models. Section 4
describes a RandomWalk Metropolis (RWM) algorithm and an Importance
Sampler (IS) algorithm that can be used to calculate the posterior
moments of DSGE model parameters and transformations thereof. We
compare the performance of the algorithms and provide an example
in which they explore the posterior distribution only locally in the
neighborhood of modes that are separated from each other by a deep
valley in the surface of the posterior density.
Model evaluation is an important part of the empirical work with
DSGE models. We consider three techniques in Section 5: posterior
predictive model checking, model comparisons based on posterior odds,
and comparisons of DSGE models to VARs. We illustrate these techniques
by ﬁtting correctly speciﬁed and misspeciﬁed DSGE models to artiﬁcial
data. In Section 6 we construct posterior distributions for DSGE model
parameters based on a secondorder accurate solution and compare them
to posteriors obtained from a linearized DSGE model. Finally, Section 7
concludes and provides an outlook on future work.
2. A PROTOTYPICAL DSGE MODEL
Our model economy consists of a ﬁnal goods producing ﬁrm, a
continuum of intermediate goods producing ﬁrms, a representative
household, and a monetary as well as a ﬁscal authority. This model has
become a benchmark speciﬁcation for the analysis of monetary policy
and is analyzed in detail, for instance, in Woodford (2003). To keep the
model speciﬁcation simple, we abstract from wage rigidities and capital
accumulation. More elaborate versions can be found in Smets and Wouters
(2003) and Christiano et al. (2005).
2.1. The Agents and Their Decision Problems
The perfectly competitive, representative, ﬁnal goods producing ﬁrm
combines a continuum of intermediate goods indexed by j ∈ [0, 1] using
the technology
Y
t
=
__
1
0
Y
t
(j )
1−v
dj
_
1
1−v
. (1)
Here 1,v > 1 represents the elasticity of demand for each intermediate
good. The ﬁrm takes input prices P
t
(j ) and output prices P
t
as given.
116 S. An and F. Schorfheide
Proﬁt maximization implies that the demand for intermediate goods is
Y
t
(j ) =
_
P
t
(j )
P
t
_
−1,v
Y
t
. (2)
The relationship between intermediate goods prices and the price of the
ﬁnal good is
P
t
=
__
1
0
P
t
(j )
v−1
v
dj
_
v
v−1
. (3)
Intermediate good j is produced by a monopolist who has access to the
linear production technology
Y
t
(j ) = A
t
N
t
(j ), (4)
where A
t
is an exogenous productivity process that is common to all
ﬁrms and N
t
(j ) is the labor input of ﬁrm j . Labor is hired in a perfectly
competitive factor market at the real wage W
t
. Firms face nominal rigidities
in terms of quadratic price adjustment costs
AC
t
(j ) =
[
2
_
P
t
(j )
P
t −1
(j )
−¬
_
2
Y
t
(j ), (5)
where [ governs the price stickiness in the economy and ¬ is the steady
state inﬂation rate associated with the ﬁnal good. Firm j chooses its labor
input N
t
(j ) and the price P
t
(j ) to maximize the present value of future
proﬁts
t
_
∞
s=0
[
s
Q
t +st
_
P
t +s
(j )
P
t +s
Y
t +s
(j ) −W
t +s
N
t +s
(j ) −AC
t +s
(j )
_
_
. (6)
Here Q
t +st
is the time t value of a unit of the consumption good in period
t +s to the household, which is treated as exogenous by the ﬁrm.
The representative household derives utility from real money balances
M
t
,P
t
and consumption C
t
relative to a habit stock. We assume that the
habit stock is given by the level of technology A
t
. This assumption ensures
that the economy evolves along a balanced growth path even if the utility
function is additively separable in consumption, real money balances,
and leisure. The household derives disutility from hours worked H
t
and
maximizes
t
_
∞
s=0
[
s
_
(C
t +s
,A
t +s
)
1−t
−1
1 −t
+,
M
ln
_
M
t +s
P
t +s
_
−,
H
H
t +s
_
_
, (7)
Bayesian Analysis of DSGE Models 117
where [ is the discount factor, 1,t is the intertemporal elasticity of
substitution, and ,
M
and ,
H
are scale factors that determine steadystate
real money balances and hours worked. We will set ,
H
= 1. The household
supplies perfectly elastic labor services to the ﬁrms taking the real wage
W
t
as given. The household has access to a domestic bond market where
nominal government bonds B
t
are traded that pay (gross) interest R
t
.
Furthermore, it receives aggregate residual real proﬁts D
t
from the ﬁrms
and has to pay lumpsum taxes T
t
. Thus the household’s budget constraint
is of the form
P
t
C
t
+B
t
+M
t
−M
t −1
+T
t
= P
t
W
t
H
t
+R
t −1
B
t −1
+P
t
D
t
+P
t
SC
t
, (8)
where SC
t
is the net cash inﬂow from trading a full set of statecontingent
securities. The usual transversality condition on asset accumulation applies,
which rules out Ponzi schemes.
Monetary policy is described by an interest rate feedback rule of the
form
R
t
= R
∗ 1−j
R
t
R
j
R
t −1
e
e
R,t
, (9)
where e
R,t
is a monetary policy shock and R
∗
t
is the (nominal) target rate.
We consider two speciﬁcations for R
∗
t
, one in which the central bank reacts
to inﬂation and deviations of output from potential output:
R
∗
t
= r ¬
∗
_
¬
t
¬
∗
_
ç
1
_
Y
t
Y
∗
t
_
ç
2
(output gap rule speciﬁcation) (10)
and a second speciﬁcation in which the central bank responds to deviations
of output growth from its equilibrium steadystate ¸:
R
∗
t
= r ¬
∗
_
¬
t
¬
∗
_
ç
1
_
Y
t
¸Y
t −1
_
ç
2
(output growth rule speciﬁcation). (11)
Here r is the steadystate real interest rate, ¬
t
is the gross inﬂation
rate deﬁned as ¬
t
= P
t
,P
t −1
, and ¬
∗
is the target inﬂation rate, which in
equilibrium coincides with the steadystate inﬂation rate. Y
∗
t
in (10) is the
level of output that would prevail in the absence of nominal rigidities.
The ﬁscal authority consumes a fraction ¸
t
of aggregate output Y
t
,
where ¸
t
∈ [0, 1] follows an exogenous process. The government levies a
lumpsum tax (subsidy) to ﬁnance any shortfalls in government revenues
(or to rebate any surplus). The government’s budget constraint is given by
P
t
G
t
+R
t −1
B
t −1
= T
t
+B
t
+M
t
−M
t −1
, (12)
where G
t
= ¸
t
Y
t
.
118 S. An and F. Schorfheide
2.2. Exogenous Processes
The model economy is perturbed by three exogenous processes.
Aggregate productivity evolves according to
lnA
t
= ln¸ +lnA
t −1
+lnz
t
, where lnz
t
= j
z
lnz
t −1
+e
z,t
. (13)
Thus on average technology grows at the rate ¸, and z
t
captures exogenous
ﬂuctuations of the technology growth rate. Deﬁne g
t
= 1,(1 −¸
t
). We
assume that
lng
t
= (1 −j
g
)lng +j
g
lng
t −1
+e
g ,t
. (14)
Finally, the monetary policy shock e
R,t
is assumed to be serially
uncorrelated. The three innovations are independent of each other at all
leads and lags and are normally distributed with means zero and standard
deviations o
z
, o
g
, and o
R
, respectively.
2.3. Equilibrium Relationships
We consider the symmetric equilibrium in which all intermediate goods
producing ﬁrms make identical choices so that the j subscript can be
omitted. The market clearing conditions are given by
Y
t
= C
t
+G
t
+AC
t
and H
t
= N
t
. (15)
Since the households have access to a full set of statecontingent claims,
Q
t +st
in (6) is
Q
t +st
= (C
t +s
,C
t
)
−t
(A
t
,A
t +s
)
1−t
. (16)
It can be shown that output, consumption, interest rates, and inﬂation have
to satisfy the following optimality conditions
1 = [
t
__
C
t +1
,A
t +1
C
t
,A
t
_
−t
A
t
A
t +1
R
t
¬
t +1
_
(17)
1 =
1
v
_
1 −
_
C
t
A
t
_
t
_
+[(¬
t
−¬)
__
1 −
1
2v
_
¬
t
+
¬
2v
_
−[[
t
__
C
t +1
,A
t +1
C
t
,A
t
_
−t
Y
t +1
,A
t +1
Y
t
,A
t
(¬
t +1
−¬)¬
t +1
_
. (18)
In the absence of nominal rigidities ([ = 0) aggregate output is given by
Y
∗
t
= (1 −v)
1,t
A
t
g
t
, (19)
Bayesian Analysis of DSGE Models 119
which is the target level of output that appears in the output gap rule
speciﬁcation.
Since the nonstationary technology process A
t
induces a stochastic
trend in output and consumption, it is convenient to express the model
in terms of detrended variables c
t
= C
t
,A
t
and y
t
= Y
t
,A
t
. The model
economy has a unique steadystate in terms of the detrended variables
that is attained if the innovations e
R,t
, e
g ,t
, and e
z,t
are zero at all times.
The steadystate inﬂation ¬ equals the target rate ¬
∗
and
r =
¸
[
, R = r ¬
∗
, c = (1 −v)
1,t
, and y = g (1 −v)
1,t
. (20)
Let ˆ x
t
= ln(x
t
,x) denote the percentage deviation of a variable x
t
from its
steadystate x. Then the model can be expressed as
1 = [
t
e
−tˆ c
t +1
+tˆ c
t
+
¨
R
t
−ˆ z
t +1
−ˆ ¬
t +1
] (21)
1 −v
v[¬
2
_
e
tˆ c
t
−1
_
=
_
e
ˆ ¬
t
−1
_
__
1 −
1
2v
_
e
ˆ ¬
t
+
1
2v
_
−[
t
__
e
ˆ ¬
t +1
−1
_
e
−tˆ c
t +1
+tˆ c
t
+ˆ y
t +1
−ˆ y
t
+ˆ ¬
t +1
_
(22)
e
ˆ c
t
−ˆ y
t
= e
−ˆ g
t
−
[¬
2
g
2
_
e
ˆ ¬
t
−1
_
2
(23)
¨
R
t
= j
R
¨
R
t −1
+(1 −j
R
)ç
1
ˆ ¬
t
+(1 −j
R
)ç
2
(ˆ y
t
− ˆ g
t
) +e
R,t
(24)
ˆ g
t
= j
g
ˆ g
t −1
+e
g ,t
(25)
ˆ z
t
= j
z
ˆ z
t −1
+e
z,t
. (26)
For the output growth rule speciﬁcation, Equation (24) is replaced by
¨
R
t
= j
R
¨
R
t −1
+(1 −j
R
)ç
1
ˆ ¬
t
+(1 −j
R
)ç
2
_
Aˆ y
t
+ ˆ z
t
_
+e
R,t
. (27)
2.4. Model Solutions
Equations (21) to (26) form a nonlinear rational expectations system
in the variables ˆ y
t
, ˆ c
t
, ˆ ¬
t
,
¨
R
t
, ˆ g
t
, and ˆ z
t
that is driven by the vector of
innovations e
t
= [e
R,t
, e
g ,t
, e
z,t
]
. This rational expectations system has to be
solved before the DSGE model can be estimated. Deﬁne
2
s
t
= [ˆ y
t
, ˆ c
t
, ˆ ¬
t
,
¨
R
t
, e
R,t
, ˆ g
t
, ˆ z
t
]
.
2
Under the output growth rule speciﬁcation for R
∗
t
the vector s
t
also contains ˆ y
t −1
.
120 S. An and F. Schorfheide
The solution of the rational expectations system takes the form
s
t
= 4(s
t −1
, e
t
; 0). (28)
From an econometric perspective, s
t
can be viewed as a (partially latent)
state vector in a nonlinear state space model and (28) is the state transition
equation.
A variety of numerical techniques are available to solve rational
expectations systems. In the context of likelihoodbased DSGE model
estimation, linear approximation methods are very popular because
they lead to a state–space representation of the DSGE model that can
be analyzed with the Kalman ﬁlter. Linearization and straightforward
manipulation of Equations (21) to (23) yields
ˆ y
t
=
t
[ˆ y
t +1
] + ˆ g
t
−
t
[ ˆ g
t +1
] −
1
t
_
¨
R
t
−
¨
t
[¬
t +1
] −
t
[ˆ z
t +1
]
_
(29)
ˆ ¬
t
= [
t
[ ˆ ¬
t +1
] +«(ˆ y
t
− ˆ g
t
) (30)
ˆ c
t
= ˆ y
t
− ˆ g
t
, (31)
where
« = t
1 −v
v¬
2
[
. (32)
Equations (29) to (31) combined with (24) to (26) and the trivial
identity e
R,t
= e
R,t
form a linear rational expectations system in s
t
for
which several solution algorithms are available, for instance, Blanchard
and Kahn (1980), Binder and Pesaran (1997), King and Watson (1998),
Uhlig (1999), Anderson (2000), Kim (2000), Christiano (2002), and Sims
(2002). Depending on the parameterization of the DSGE model there are
three possibilities: no stable rational expectations solution exists, the stable
solution is unique (determinacy), or there are multiple stable solutions
(indeterminacy). We will focus on the case of determinacy and restrict
the parameter space accordingly. The resulting law of motion for the j th
element of s
t
takes the form
s
j ,t
=
J
i=1
4
(s)
j ,i
s
i,t −1
+
n
l =1
4
(e)
j ,l
e
l ,t
, j = 1, . . . , J . (33)
Here J denotes the number of elements of the vector s
t
and n is the
number of shocks stacked in the vector e
t
. Here the coefﬁcients 4
(s)
j ,i
and
4
(e)
j ,l
are functions of the structural parameters of the DSGE model.
While in many applications ﬁrstorder approximations are sufﬁcient,
the higherorder reﬁnement is an active area of research. For instance,
Bayesian Analysis of DSGE Models 121
if the goal of the analysis is to compare welfare across policies or market
structures that do not have ﬁrstorder effects on the model’s steadystate
or to study asset pricing implications of DSGE models, a more accurate
solution may be necessary; see, for instance, Kim and Kim (2003) or
Woodford (2003). A simple example can illustrate this point. Consider a
oneperiod model in which utility is a smooth function of consumption and
is approximated as
U(ˆ c) = U(0) +U
(1)
(0)ˆ c +
1
2
U
(2)
(0)ˆ c
2
+o(ˆ c
2
), (34)
where ˆ c is the percentage deviation of consumption from its steadystate
and the superscript i denotes the ith derivative. Suppose that consumption
is a smooth function of a zero mean random shock e which is scaled by o.
The secondorder approximation of ˆ c around the steadystate (o = 0) is
ˆ c = C
(1)
(c)oe +
1
2
C
(2)
(c)o
2
e
2
+o
p
(o
2
). (35)
If ﬁrstorder approximations are used for both U and C, then the expected
utility is simply approximated by the steadystate utility U(0), which, for
instance, in the DSGE model described above, is not affected by the
coefﬁcients ç
1
and ç
2
of the monetary policy rule (24). A secondorder
approximation of both U and C leads to
[U(ˆ c)] = U(0) +
1
2
U
(2)
(0)C
(1)
2
(c)o
2
+
1
2
U
(1)
(0)C
(2)
(c)o
2
+o(o
2
). (36)
Using a secondorder expansion of the utility function together with a ﬁrst
order expansion of consumption ignores the second term in (36) and is
only appropriate if either U
(1)
(0) or C
(2)
(c) is zero. The ﬁrst case arises
if the marginal utility of consumption in the steadystate is zero, and the
second case arises if the percentage deviation of consumption from the
steadystate is a linear function of the shock.
A secondorder accurate solution to the DSGE model can be obtained
from a secondorder expansion of the equilibrium conditions (21) to (26).
Algorithms to construct such solutions have been developed by Judd
(1998), Collard and Juillard (2001), Jin and Judd (2002), Schmitt
Grohé and Uribe (2006), Kim et al. (2005), and Swanson et al. (2005).
The resulting state transition equation can be expressed as
s
j ,t
= 4
(0)
j
+
J
i=1
4
(s)
j ,i
s
i,t −1
+
n
l =1
4
(e)
j ,l
e
l ,t
+
J
i=1
J
l =1
4
(ss)
j ,il
s
i,t −1
s
l ,t −1
+
J
i=1
n
l =1
4
(se)
j ,il
s
i,t −1
e
l ,t
+
n
i=1
n
l =1
4
(ee)
j ,il
e
i,t
e
l ,t
. (37)
122 S. An and F. Schorfheide
As before, the coefﬁcients are functions of the parameters of the DSGE
model. For the subsequent analysis we use Sims’ (2002) procedure to
compute a ﬁrstorder accurate solution of the DSGE model and Schmitt
Grohé and Uribe’s (2006) algorithm to obtain a secondorder accurate
solution.
While perturbation methods approximate policy functions only locally,
there are several global approximation schemes, including projection
methods such as the ﬁniteelements method and Chebyshev–polynomial
method on the spectral domain. Judd (1998) covers various solution
methods, and Taylor and Uhlig (1990), Den Haan and Marcet (1994), and
Aruoba et al. (2004) compare the accuracy of alternative solution methods.
2.5. Measurement Equations
The model is completed by deﬁning a set of measurement equations
that relate the elements of s
t
to a set of observables. We assume that
the time period t in the model corresponds to one quarter and that the
following observations are available for estimation: quartertoquarter per
capita GDP growth rates (YGR), annualized quartertoquarter inﬂation
rates (INFL), and annualized nominal interest rates (INT). The three
series are measured in percentages, and their relationship to the model
variables is given by the set of equations
YGR
t
= ¸
(Q)
+100(ˆ y
t
− ˆ y
t −1
+ ˆ z
t
)
INFL
t
= ¬
(A)
+400ˆ ¬
t
(38)
INT
t
= ¬
(A)
+r
(A)
+4¸
(Q)
+400
¨
R
t
.
The parameters ¸
(Q)
, ¬
(A)
, and r
(A)
are related to the steady states of the
model economy as
¸ = 1 +
¸
(Q)
100
, [ =
1
1 +r
(A)
,400
, ¬ = 1 +
¬
(A)
400
.
The structural parameters are collected in the vector 0. Since in the
ﬁrstorder approximation the parameters v and [ are not separately
identiﬁable, we express the model in terms of «, deﬁned in (32). Let
0 = [t, «, ç
1
, ç
2
, j
R
, j
g
, j
z
, r
(A)
, ¬
(A)
, ¸
(Q)
, o
R
, o
g
, o
z
]
.
For the quadratic approximation the composite parameter « will be
replaced by either ([, v) or alternatively by («, v). Moreover, 0 will be
augmented with the steadystate ratio c,y, which is equal to 1,g .
Bayesian Analysis of DSGE Models 123
3. PRELIMINARIES
Numerous formal and informal econometric procedures have been
proposed to parameterize and evaluate DSGE models, ranging from
calibration, e.g., Kydland and Prescott (1982), over generalized method of
moments (GMM) estimation of equilibrium relationships, e.g., Christiano
and Eichenbaum (1992), minimum distance estimation based on the
discrepancy among VAR and DSGE model impulse response functions,
e.g., Rotemberg and Woodford (1997) and Christiano et al. (2005), to
fullinformation likelihoodbased estimation as in Altug (1989), McGrattan
(1994), Leeper and Sims (1994), and Kim (2000). Much of the
methodological debate surrounding the various estimation (and model
evaluation) techniques is summarized in papers by Kydland and Prescott
(1996), Hansen and Heckman (1996), and Sims (1996).
We focus on Bayesian estimation of DSGE models, which has three
main characteristics. First, unlike GMM estimation based on equilibrium
relationships such as the consumption Euler equation (21), the price
setting equation of the intermediate goods producing ﬁrms (22), or the
monetary policy rule (24), the Bayesian analysis is systembased and ﬁts
the solved DSGE model to a vector of aggregate time series. Second,
the estimation is based on the likelihood function generated by the
DSGE model rather than, for instance, the discrepancy between DSGE
model responses and VAR impulse responses. Third, prior distributions
can be used to incorporate additional information into the parameter
estimation. Any estimation and evaluation method is confronted with the
following challenges: potential model misspeciﬁcation and possible lack
of identiﬁcation of parameters of interest. We will subsequently elaborate
these challenges and discuss how a Bayesian approach can be used to cope
with them.
Throughout the paper we will use the following notation: the n ×1
vector y
t
stacks the time t observations that are used to estimate the DSGE
model. In the context of the model developed in Section 2 y
t
is composed
of YGR
t
, INFL
t
, INT
t
. The sample ranges from t = 1 to T and the sample
observations are collected in the matrix Y with rows y
t
. We denote the
prior density by p(0), the likelihood function by (0  Y ), and the posterior
density by p(0  Y ).
3.1. Potential Model Misspeciﬁcation
If one predicts a vector of time series y
t
, for instance composed of
output growth, inﬂation, and nominal interest rates, by a function of past
y
t
’s, then the resulting forecast error covariance matrix is nonsingular.
Hence any DSGE model that generates a rankdeﬁcient covariance matrix
for y
t
is clearly at odds with the data and suffers from an obvious form
124 S. An and F. Schorfheide
of misspeciﬁcation. This singularity is an obstacle to likelihood estimation.
Hence one branch of the literature has emphasized procedures that can
be applied despite the singularity, whereas the other branch has modiﬁed
the model speciﬁcation to remove the singularity by adding socalled
measurement errors, e.g., Sargent (1989), Altug (1989), Ireland (2004),
or additional structural shocks as in Leeper and Sims (1994) and more
recently Smets and Wouters (2003). In this paper we pursue the latter
approach by considering a model in which the number of structural shocks
(monetary policy shock, government spending shock, technology growth
shock) equals the number of observables (output growth, inﬂation, interest
rates) to which the model is ﬁtted.
A second source of misspeciﬁcation that is more difﬁcult to correct
is potentially invalid crosscoefﬁcient restrictions on the time series
representation of y
t
generated by the DSGE model. Invalid restrictions
manifest themselves in poor outofsample ﬁt relative to more densely
parameterized reference models such as VARs. Del Negro et al. (2006)
document that even an elaborate DSGE model with capital accumulation
and various nominal and real frictions has difﬁculties attaining the ﬁt
achieved with VARs that have been estimated with welldesigned shrinkage
methods. While the primary research objectives in the DSGE model
literature is to overcome discrepancies between models and reality, it is
important to have empirical strategies available that are able to cope with
potential model misspeciﬁcation.
Once one acknowledges that the DSGE model provides merely an
approximation to the law of motion of the time series y
t
, then it seems
reasonable to assume that there need not exist a single parameter vector
0
0
that delivers, say, the “true” intertemporal substitution elasticity or price
adjustment costs and, simultaneously, the most precise impulse responses
to a technology or monetary policy shock. Each estimation method is
associated with a particular measure of discrepancy between the ‘true’
law of motion and the class of approximating models. Likelihoodbased
estimators, for instance, asymptotically minimize the Kullback–Leibler
distance (see White, 1982).
One reason that pure maximum likelihood estimation of DSGE models
has not turned into the estimation method of choice is the “dilemma of
absurd parameter estimates.” Estimates of structural parameters generated
with maximum likelihood procedures based on a set of observations Y
are often at odds with additional information that the research may have.
For example, estimates of the discount factor [ should be consistent with
our knowledge about the average magnitude of real interest rates, even if
observations on interest rates are not included in the estimation sample
Y . Time series estimates of aggregate labor supply elasticities or price
adjustment costs should be broadly consistent with microlevel evidence.
However, due to the stylized nature and the resulting misspeciﬁcation
Bayesian Analysis of DSGE Models 125
of most DSGE models, the likelihood function often peaks in regions
of the parameter space that appear to be inconsistent with extraneous
information.
In a Bayesian framework, the likelihood function is reweighted by a
prior density. The prior can bring to bear information that is not contained
in the estimation sample Y . Since priors are always subject to revision, the
shift from prior to posterior distribution can be an indicator of the tension
between different sources of information. If the likelihood function peaks
at a value that is at odds with the information that has been used to
construct the prior distribution, then the marginal data density of the
DSGE model, deﬁned as
p(Y ) =
_
(0  Y )p(0)d0, (39)
will be low compared to, say, a VAR, and in a posterior odds comparison
the DSGE model will automatically be penalized for not being able to
reconcile the two sources of information with a single set of parameters.
Section 5 will discuss several methods that have been proposed to assess
the ﬁt of DSGE models: posterior odds comparisons of competing model
speciﬁcations, posterior predictive checks, and comparisons to reference
models that relax some of the crosscoefﬁcient restrictions generated by the
DSGE models.
3.2. Identiﬁcation
Identiﬁcation problems can arise owing to a lack of informative
observations or, more fundamentally, from a probability model that
implies that different values of structural parameters lead to the same
joint distribution for the observables Y . At ﬁrst glance the identiﬁcation
of DSGE model parameters does not appear to be problematic. The
parameter vector 0 is typically low dimensional compared to VARs and
the model imposes tight restrictions on the time series representation
of Y . However, recent experience with the estimation of New Keynesian
DSGE models has cast some doubt on this notion and triggered a more
careful assessment. Lack of identiﬁcation is documented in papers by
Beyer and Farmer (2004) and Canova and Sala (2005). The former paper
provides an algorithm to construct families of observationally equivalent
linear rational expectations models, whereas the latter paper compares
the informativeness of different estimators with respect to key structural
parameters in a variety of DSGE models.
The delicate identiﬁcation problems that arise in rational expectations
models can be illustrated in a simple example adopted from Lubik and
Schorfheide (2006). Consider the following two models, in which y
t
is
126 S. An and F. Schorfheide
the observed endogenous variable and u
t
is an unobserved shock process.
In model
1
, the u
t
’s are serially correlated:
1
: y
t
=
1
:
t
[y
t +1
] +u
t
, u
t
= ju
t −1
+e
t
, e
t
∼ iid
_
0, (1 −j,:)
2
_
.
(40)
In model
2
the shocks are serially uncorrelated, but we introduce
a backwardlooking term [y
t −1
on the righthand side to generate
persistence:
2
: y
t
=
1
:
t
[y
t +1
] +[y
t −1
+u
t
, u
t
= e
t
,
e
t
∼ iid
_
0,
_
: +
_
:
2
−4[:
2:
_
2
_
.
(41)
For both speciﬁcations, the law of motion of y
t
is
y
t
= çy
t −1
+p
t
, p
t
∼ iid(0, 1). (42)
Under restrictions on the parameter spaces that guarantee uniqueness of a
stable rational expectations solution
3
we obtain the following relationships
between ç and the structural parameters:
1
: ç = j,
2
: ç =
1
2
(: −
_
:
2
−4[:).
In model
1
the parameter : is not identiﬁable, and in model
2
, the
parameters : and [ are not separately identiﬁable. Moreover, models
1
and
2
are observationally equivalent. The likelihood functions of
1
and
2
have ridges that can cause serious problems for numerical optimization
procedures. The calculation of a valid conﬁdence set is challenging since it
is difﬁcult to trace out the parameter subspace along which the likelihood
function is constant.
While Bayesian inference is based on the likelihood function, even a
weakly informative prior can introduce curvature into the posterior density
surface that facilitates numerical maximization and the use of MCMC
methods. Consider model
1
. Here 0 = [j, :]
and the likelihood function
can be written as (j, :  Y ) =
(j). Straightforward manipulations of the
Bayes theorem yield
p(j, :  Y ) = p(j  Y )p(:  j). (43)
3
To ensure determinacy we impose : > 1 in
1
and  : −
_
:
2
−4[:   2 and
 : +
_
:
2
−4[:  > 2 in
2
.
Bayesian Analysis of DSGE Models 127
Thus the prior distribution is not updated in directions of the parameter
space in which the likelihood function is ﬂat. This is of course well known
in Bayesian econometrics; see Poirier (1998) for a discussion.
It is difﬁcult to detect directly identiﬁcation problems in large DSGE
models, since the mapping from the vector of structural parameters 0
into the state–space representation that determines the joint probability
distribution of Y is highly nonlinear and typically can only be evaluated
numerically. The posterior distribution is well deﬁned as long as the
joint prior distribution of the parameters is proper. However, lack of
identiﬁcation provides a challenge for scientiﬁc reporting, as the audience
typically would like to know what features of the posterior are generated
by the prior rather than the likelihood. A direct comparison of priors and
posteriors can often provide valuable insights about the extent to which
data provide information about the parameters of interest.
3.3. Priors
As indicated in our previous discussion, prior distributions will play an
important role in the estimation of DSGE models. They might downweigh
regions of the parameter space that are at odds with observations not
contained in the estimation sample Y . They might also add curvature
to a likelihood function that is (nearly) ﬂat in some dimensions of
the parameter space and therefore strongly inﬂuence the shape of the
posterior distribution.
4
While, in principle, priors can be gleaned from
personal introspection to reﬂect strongly held beliefs about the validity
of economic theories, in practice most priors are chosen based on some
observations.
For instance, Lubik and Schorfheide (2006) estimate a twocountry
version of the model described in Section 2. Priors for the autocorrelations
and standard deviations of the exogenous processes, the steadystate
parameters ¸
(Q)
, ¬
(A)
, and r
(A)
, as well as the standard deviation of the
monetary policy shock, are quantiﬁed based on regressions run on pre
(estimation)sample observations of output growth, inﬂation, and nominal
interest rates. The priors for the coefﬁcients in the monetary policy rule
are loosely centered around values typically associated with the Taylor rule.
The prior for the parameter that governs price stickiness is chosen based
on microevidence on price setting behavior provided, for instance, in Bils
and Klenow (2004). To ﬁnetune the prior distribution, in particular the
distribution of shock standard deviations, it is often helpful to simulate the
prior predictive distribution for various sample moments and check that
4
The role of priors in DSGE model estimation is markedly different from the role of priors
in VAR estimation. In the latter case priors are essentially used to reduce the dimensionality of the
econometric model and hence the sampling variability of the parameter estimates.
128 S. An and F. Schorfheide
the prior does not place little or no mass in a neighborhood of important
features of the data. Such an occurrence would suggest that the model is
incapable of explaining salient data properties. A formalization of such a
prior predictive check can be found in Geweke (2005).
Table 2 lists the marginal prior distributions for the structural
parameters of the DSGE model, that we will use in the subsequent
analysis. These priors are adopted from Lubik and Schorfheide (2006). For
convenience, it is assumed that all parameters are a priori independent.
In applications in which the independence assumption is unreasonable
one could derive parameter transformations, such as steady rate ratios,
autocorrelations, or relative volatilities, and specify independent priors
on the transformed parameters, which induce dependent priors for the
original parameters. As mentioned before, rational expectations models
can have multiple equilibria. While this may be of independent interest we
do not pursue this direction in this paper. Hence, the prior distribution
is truncated at the boundary of the determinacy region. Prior to the
truncation the distribution speciﬁed in Table 2 places about 2% of its
mass on parameter values that imply indeterminacy. The parameters v
(conditional on «) and 1,g only affect the secondorder approximation of
the DSGE model.
3.4. The Road Ahead
Throughout this paper we are estimating and evaluating versions of
the DSGE model presented in Section 2 based on simulated data. Table 1
provides a characterization of the model speciﬁcations and data sets.
TABLE 1 Model speciﬁcations and data sets
1
(L) Benchmark Model with output gap rule, consists of Eqs. (21)–(26), solved by ﬁrstorder
approximation.
1
(Q) Benchmark Model with output gap rule, consists of Eqs. (21)–(26), solved by secondorder
approximation.
2
(L) DSGE Model with output growth rule, consists of Eqs. (21)–(26), however, Eq. (24) is
replaced by Eq. (27), solved by ﬁrstorder approximation.
3
(L) Same as
1
(L), except that prices are nearly ﬂexible: « = 5.
4
(L) Same as
1
(L), except that central bank does not respond to the output gap: ç
2
= 0.
5
(L) Same as
1
(L), except in ﬁrstorder approximation Eq. (29)is replaced by
(1 +h)ˆ y
t
=
¨
t
[y
t +1
] +hˆ y
t −1
+ ˆ g
t
−
t
[ ˆ g
t +1
] −
1
t
_
¨
R
t
−
¨
t
[¬
t +1
] −[ˆ z
t +1
]
_
with h = .95.
1
(L) 80 observations generated with
1
(L)
1
(Q) 80 observations generated with
1
(Q)
2
(L) 80 observations generated with
2
(L)
5
(L) 80 observations generated with
5
(L)
Bayesian Analysis of DSGE Models 129
Model
1
is the benchmark speciﬁcation of the DSGE model in which
monetary policy follows an interestrate rule that reacts to the output gap.
1
(L) is approximated by a linear rational expectations system, whereas
1
(Q) is solved with a secondorder perturbation method. In
2
(L) we
replace the output gap in the interestrate feedback rule by output growth.
3
and
4
are identical to
1
(L), except that in one case we impose that
the prices are nearly ﬂexible (« = 5) and in the other case the central
bank does not respond to output (ç
2
= 0). In
5
(L) we replace the log
linearized consumption Euler equation by an equation that includes lagged
output on the righthand side. Loosely speaking, this speciﬁcation can be
motivated with a model in which agents derive utility from the difference
between individual consumption and the overall level of consumption in
the previous period.
Conditional on parameter vectors reported in Tables 2 and 3 we
generate four data sets with 80 observations each. We use the labels
1
(L),
1
(Q),
2
(L), and
5
(L) to denote data sets generated from
1
(L),
1
(Q),
2
(L), and
5
(L), respectively. By and large, the values for the
DSGE model parameters resemble empirical estimates obtained from post
1982 U.S. data. The sample size is fairly realistic for the estimation of
monetary DSGE model. Many industrialized countries experienced a high
inﬂation episode in the 1970s that ended with a disinﬂation in the 1980s.
Subsequently, the level and the variability of inﬂation and interest rates
have been fairly stable, so that it is not uncommon to estimate constant
coefﬁcient DSGE models based on data sets that begin in the early 1980s.
TABLE 2 Prior distribution and DGPs—linear analysis (Sections 4 and 5)
Prior
DGP
Name Domain Density Para (1) Para (2)
1
(L),
2
(L),
5
(L)
t
+
Gamma 2.00 .50 2.00
«
+
Gamma .20 .10 .15
ç
1
+
Gamma 1.50 .25 1.50
ç
2
+
Gamma .50 .25 1.00
j
R
[0, 1) Beta .50 .20 .60
j
G
[0, 1) Beta .80 .10 .95
j
Z
[0, 1) Beta .66 .15 .65
r
(A)
+
Gamma .50 .50 .40
¬
(A)
+
Gamma 7.00 2.00 4.00
¸
(Q)
Normal .40 .20 .50
100o
R
+
InvGamma .40 4.00 .20
100o
G
+
InvGamma 1.00 4.00 .80
100o
Z
+
InvGamma .50 4.00 .45
Notes: Paras (1) and (2) list the means and the standard deviations for Beta, Gamma, and Normal
distributions; the upper and lower bound of the support for the Uniform distribution; s and v for
the Inverse Gamma distribution, where p
G
(o  v, s) ∝ o
−v−1
e
−vs
2
,2o
2
. The effective prior is truncated
at the boundary of the determinacy region.
130 S. An and F. Schorfheide
TABLE 3 Prior distribution and DGP—Nonlinear analysis (Section 6)
Prior
DGP
Name Domain Density Para (1) Para (2)
1
(Q)
t
+
Gamma 2.00 .50 2.00
«
+
Gamma .30 .20 .33
ç
1
+
Gamma 1.50 .25 1.50
ç
2
+
Gamma .50 .25 .125
j
R
[0, 1) Beta .50 .20 .75
j
G
[0, 1) Beta .80 .10 .95
j
Z
[0, 1) Beta .66 .15 .90
r
(A)
+
Gamma .80 .50 1.00
¬
(A)
+
Gamma 4.00 2.00 3.20
¸
(Q)
Normal .40 .20 .55
100o
R
+
InvGamma .30 4.00 .20
100o
G
+
InvGamma .40 4.00 .60
100o
Z
+
InvGamma .40 4.00 .30
v [0, 1) Beta .10 .05 .10
1,g [0, 1) Beta .85 .10 .85
Notes: See Table 2. Parameters v and 1,g only affect the secondorder accurate
solution of the DSGE model.
Section 4 illustrates the estimation of linearized DSGE models under
correct speciﬁcation, that is, we construct posteriors for
1
(L) and
2
(L) based on the data sets
1
(L) and
2
(L). Section 5 considers
model evaluation techniques. We begin with posterior predictive checks
in Section 5.1, which are implemented based on
1
(L) for data sets
1
(L) (correct speciﬁcation of DSGE model) and
5
(L) (misspeciﬁcation
of the consumption Euler equation). In Section 5.2 we proceed with
the calculation of posterior model probabilities for speciﬁcations
1
(L),
3
(L), and
4
(L) conditional on the data set
1
(L). Subsequently in
Section 5.3 we compare
1
(L) to a vector autoregressive speciﬁcation
using
1
(L) (correct speciﬁcation) and
5
(L) (misspeciﬁcation). Finally,
in Section 6 we study the estimation of DSGE models solved with a second
order perturbation method. We compare posteriors for
1
(Q) and
1
(L)
conditional on
1
(Q).
4. ESTIMATION OF LINEARIZED DSGE MODELS
We will begin by describing two algorithms that can be used to generate
draws from the posterior distribution of 0 and subsequently illustrate their
performance in the context of models
1
(L),
1
(L) and
2
(L),
2
(L).
4.1. Posterior Computations
We consider an RWM algorithm and an IS algorithm to generate draws
from the posterior distribution of 0. Both algorithms require the evaluation
Bayesian Analysis of DSGE Models 131
of (0  Y )p(0). The computation of the nonnormalized posterior density
proceeds in two steps. First, the linear rational expectations system is solved
to obtain the state transition equation (33). If the parameter value 0
implies indeterminacy (or nonexistence of a stable rational expectations
solution), then (0  Y )p(0) is set to zero. If a unique stable solution
exists, then the Kalman ﬁlter
5
is used to evaluate the likelihood function
associated with the linear state–space system (33) and (38). Since the
prior is generated from wellknown densities, the computation of p(0) is
straightforward.
The RWM algorithm belongs to the more general class of Metropolis–
Hastings algorithms. This class is composed of universal algorithms that
generate Markov chains with stationary distributions that correspond
to the posterior distributions of interest. A ﬁrst version of such an
algorithm had been constructed by Metropolis et al. (1953) to solve a
minimization problem and was later generalized by Hastings (1970). Chib
and Greenberg (1995) provide an excellent introduction to Metropolis–
Hastings algorithms. The RWM algorithm was ﬁrst used to generate draws
from the posterior distribution of DSGE model parameters by Schorfheide
(2000) and Otrok (2001). We will use the following implementation based
on Schorfheide (2000):
6
RandomWalk Metropolis (RWM) Algorithm
1. Use a numerical optimization routine to maximize ln(0  Y ) +lnp(0).
Denote the posterior mode by
˜
0.
2. Let
¯
l be the inverse of the Hessian computed at the posterior mode
˜
0.
3. Draw 0
(0)
from (
˜
0, c
2
0
¯
l) or directly specify a starting value.
4. For s = 1, . . . , n
sim
, draw 6 from the proposal distribution (0
(s−1)
, c
2
¯
l).
The jump from 0
(s−1)
is accepted (0
(s)
= 6) with probability
min]1, r (0
(s−1)
, 6  Y )] and rejected (0
(s)
= 0
(s−1)
) otherwise. Here
r (0
(s−1)
, 6  Y ) =
(6  Y )p(6)
(0
(s−1)
 Y )p(0
(s−1)
)
.
5. Approximate the posterior expected value of a function h(0) by
1
n
sim
n
sim
s=1
h(0
(s)
).
5
Since according to our model s
t
is stationary, the Kalman ﬁlter can be initialized with the
unconditional distribution of s
t
. To make the estimation in Section 4 comparable to the DSGE
VAR analysis presented in Section 5.3 we adjust the likelihood function to condition on the ﬁrst
four observations in the sample: (0  Y ),(0  y
1
, . . . , y
4
). These four observations are later used to
initialize the lags of a VAR.
6
This version of the algorithm is available in the userfriendly DYNARE (2005) package, which
automates the Bayesian estimation of linearized DSGE models and provides routines to solve DSGE
models with higherorder perturbation methods.
132 S. An and F. Schorfheide
Under fairly general regularity conditions, e.g., Walker (1969),
Crowder (1988), and Kim (1998), the posterior distribution of 0 will be
asymptotically normal. The algorithm constructs a Gaussian approximation
around the posterior mode and uses a scaled version of the asymptotic
covariance matrix as the covariance matrix for the proposal distribution.
This allows for an efﬁcient exploration of the posterior distribution at least
in the neighborhood of the mode.
The maximization of the posterior density kernel is carried out with
a version of the BFGS quasiNewton algorithm, written by Chris Sims
for the maximum likelihood estimation of a DSGE model conducted in
Leeper and Sims (1994). The algorithm uses a fairly simple line search
and randomly perturbs the search direction if it reaches a cliff caused by
nonexistence or nonuniqueness of a stable rational expectations solution
for the DSGE model. Prior to the numerical maximization we transform
all parameters so that their domain is unconstrained. This parameter
transformation is only used in Step 1 of the RWM algorithm. The elements
of the Hessian matrix in Step 2 are computed numerically for various
values of the increment d0. There typically exists a range for d0 over which
the derivatives are stable. As d0 approaches zero the numerical derivatives
will eventually deteriorate owing to inaccuracies in the evaluation of
the objective function. While Steps 1 and 2 are not necessary for the
implementation of the RWM algorithm, they are often helpful.
The RWM algorithm generates a sequence of dependent draws from
the posterior distribution of 0 that can be averaged to approximate
posterior moments. Geweke (1999a, 2005) reviews regularity conditions
that guarantee the convergence of the Markov chain generated by
Metropolis–Hastings algorithms to the posterior distribution of interest
and the convergence of
1
n
sim
n
sim
s=1
h(0
(s)
) to the posterior expectations
[h(0)  Y ].
DeJong et al. (2000) used an IS algorithm to calculate posterior
moments of the parameters of a linearized stochastic growth model. The
idea of the algorithm is based on the identity
[h(0)  Y ] =
_
h(0)p(0  Y )d0 =
_
h(0)p(0  Y )
q(0)
q(0)d0.
Draws from the posterior density p(0  Y ) are replaced by draws from
the density q(0) and reweighted by the importance ratio p(0  Y ),q(0) to
obtain a numerical approximation of the posterior moment of interest.
Hammersley and Handscomb (1964) were among the ﬁrst to propose this
method and Geweke (1989) provides important convergence results. The
particular version of the IS algorithm used subsequently is of the following
form.
Bayesian Analysis of DSGE Models 133
Importance Sampling (IS) Algorithm
1. Use a numerical optimization routine to maximize ln(0  Y ) +lnp(0).
Denote the posterior mode by
˜
0.
2. Let
¯
l be the inverse of the Hessian computed at the posterior mode
˜
0.
3. Let q(0) be the density of a multivariate t distribution with mean
˜
0, scale
matrix c
2
¯
l, and v degrees of freedom.
4. For s = 1, . . . , n
sim
generate draws 0
(s)
from q(0).
5. Compute ˜ w
s
= (0
(s)
 Y )p(0
(s)
),q(0
(s)
) and w
s
= ˜ w
s
,
n
sim
s=1
˜ w
s
.
6. Approximate the posterior expected value of a function h(0) by
n
sim
s=1
w(0
(s)
)h(0
(s)
).
The accuracy of the IS approximation depends on the similarity
between posterior kernel and importance density. If the two are equal, then
the importance weights w
s
are constant and one averages independent
draws to approximate the posterior expectations of interest. If the
importance density concentrates its mass in a region of the parameter
space in which the posterior density is very low, then most of the w
s
’s will be
much smaller than 1,n
sim
and the approximation method is inefﬁcient. We
construct a Gaussian approximation of the posterior near the mode, scale
the asymptotic covariance matrix, and replace the normal distribution with
a fattailed t distribution to implement the algorithm.
4.2. Simulation Results for
1
(L)/
1
(L)
We begin by estimating the loglinearized output gap rule speciﬁcation
1
(L) based on data set
1
(L). We use the RWM algorithm (c
0
= 1, c =
0.3) to generate 1 million draws from the posterior distribution. The
rejection rate is about 45%. Moreover, we generate 200 independent draws
from the truncated prior distribution. Figure 1 depicts the draws from
the prior as well as every 5,000th draw from the posterior distribution
in twodimensional scatter plots. We also indicate the location of the
posterior mode in the 12 panels of the ﬁgure. A visual comparison of
priors and posteriors suggests that the 80 observations sample contains
little information on the riskaversion parameter t and the policy rule
coefﬁcients ç
1
and ç
2
. There is, however, information about the degree
of pricestickiness, captured by the slope coefﬁcient « of the Phillipscurve
relationship (30). Moreover, the posteriors of steadystate parameters, the
autocorrelation coefﬁcients, and the shock standard deviations are sharply
peaked relative to the prior distributions. The lack of information about
some of the key structural parameters resembles the empirical ﬁndings
based on actual observations.
There exists an extensive literature on convergence diagnostics for
MCMC methods such as the RWM algorithm. An introduction to this
134 S. An and F. Schorfheide
FIGURE 1 Prior and posterior – Model
1
(L), Data
1
(L). The panels depict 200 draws from
prior and posterior distributions. Intersections of solid lines signify posterior mode values.
literature can be found, for instance, in Robert and Casella (1999).
These authors distinguish between convergence of the Markov chain to
its stationary distribution, convergence of empirical averages to posterior
moments, and convergence to iid sampling. While many convergence
diagnostics are based on formal statistical tests, we will consider informal
graphical methods in this paper. More speciﬁcally, we will compare draws
and recursively computed means from multiple chains.
We run four independent Markov chains. Except for t and ç
2
, all
parameters are initialized at their posterior mode values. The initial values
for (t, ç
2
) are (3.0, .1), (3.0, 2.0), (.4, .1), and (.6, 2.0), respectively. As
before, we set c = 0.3, generate 1 million draws for each chain, and plot
every 5,000th draw of (t, ç
2
) in Figure 2. Panels (1, 1) and (1, 2) of the
ﬁgure depict posterior contours at the posterior mode. Visual inspection of
Bayesian Analysis of DSGE Models 135
FIGURE 2 Draws from multiple chains – Model
1
(L), Data
1
(L). Panels (1,1) and (1,2): contours
of posterior density at “low” and “high” mode as function of t and ç
2
. Panels (2,1) to (3,2): 200
draws from four Markov chains generated by the Metropolis Algorithm. Intersections of solid lines
signify posterior mode values.
the plots suggests that all four chains, despite the use of different starting
values, converge to the same (stationary) distribution and concentrate in
the highposterior density region. Figure 3 plots recursive means for the
four chains. Despite different initializations, the means converge in the
long run.
We generate another set of 1 million draws using the IS algorithm with
v = 3 and c = 1.5. As for the draws from the RWM algorithm, we compute
recursive means. Since neither the IS nor the RWM approximation of the
posterior means are exact, we construct standard error estimates. For the
importance sampler we follow Geweke (1999b), and for the Metropolis
chain we use Newey–West standard error estimates, truncated at 140 lags.
7
In Figure 4 we plot (recursive) conﬁdence intervals for the RWM and the
IS approximation of the posterior means. For most parameters the two
7
It is not guaranteed that the Newey–West standard errors are formally valid.
136 S. An and F. Schorfheide
FIGURE 3 Recursive means from multiple chains – Model
1
(L), Data
1
(L). Each line
corresponds to recursive means (as a function of the number of draws) calculated from one of the
four Markov chains generated by the Metropolis Algorithm.
conﬁdence intervals overlap. Exceptions are, for instance, «, r
(A)
, j
g
, and
o
g
. However, the magnitude of the discrepancy is generally small relative to,
say, the difference between the posterior mode and the estimated posterior
means.
4.3. A Potential Pitfall: Simulation Results for
2
(L)/
2
(L)
We proceed by estimating the output growth rule version
2
(L) of the
DSGE model based on 80 observations generated from this model (Data
Set
2
(L)). Unlike the posterior for the output gap version, the
2
(L)
posterior has (at least) two modes. One of the modes, which we label
the “high” mode,
˜
0
(h)
, is located at t = 2.06 and ç
2
= .97. The value of
Bayesian Analysis of DSGE Models 137
FIGURE 4 RWM algorithm vs. Importance Sampling – Model
1
(L), Data
1
(L). Panels depict
posterior modes (solid), recursively computed 95% bands for posterior means based on the
metropolis algorithm (dotted) and the importance sampler (dashed).
ln[(0  Y )p(0)] is equal to −175.48. The second (“low”) mode,
˜
0
(l )
, is
located at t = 1.44 and ç
2
= .81 and attains the value −183.23. The ﬁrst
two panels of Figure 5 depict the contours of the nonnormalized posterior
density as a function of t and ç
2
at the low and the high mode, respectively.
Panel (1,1) is constructed by setting 0 =
˜
0
(l )
and then graphing posterior
contours for t ∈ [0, 3] and ç
2
∈ [0, 2.5], keeping all other parameters ﬁxed
at their respective
˜
0
(l )
values. Similarly, Panel (1,2) is obtained by exploring
the shape of the posterior as a function of t and ç
2
, ﬁxing the other
parameters at their respective
˜
0
(h)
values. The intersection of the solid
lines in panels (1,1), (2,1), and (3,1) signify the low mode, whereas the
solid lines in the remaining panels indicate the location of the high mode.
138 S. An and F. Schorfheide
FIGURE 5 Draws from multiple chains – Model
2
(L), Data
2
(L). Panels (1,1) and (1,2): contours
of posterior density at “low” and “high” mode as function of t and ç
2
. Panels (2,1) to (3,2): 200
draws from four Markov chains generated by the metropolis algorithm. Intersections of solid lines
signify “low” (left panels) and “high” (right panels) posterior mode values.
The two modes are separated by a deep valley which is caused by complex
eigenvalues of the state transition matrix.
As in Section 4.2 we generate 1 million draws each for model
2
from
four Markov chains that were initialized at the following values for (t; ç
2
):
(3.0; .1), (3.0; 2.0), (.4; .1), and (.6; 2.0). The remaining parameters were
initialized at the low (high) mode for Chains 1 and 3 (2 and 4).
8
We plot
every 5,000th draw of t and ç
2
from the four Markov chains in Panels (2,1)
to (3,2). Unlike in Panels (1,1) and (1,2), the remaining parameters are
not ﬁxed at their
˜
0
(l )
and
˜
0
(h)
values. It turns out that Chains 1 and 3
explore the posterior distribution locally in the neighborhood of the low
mode, whereas Chains 2 and 4 move through the posterior surface near the
high mode. Given the conﬁguration of the RWM algorithm the likelihood
8
The covariance matrices of the proposal distributions are obtained from the Hessians
associated with the respective modes.
Bayesian Analysis of DSGE Models 139
of crossing the valley that separates the two modes is so small that it did not
occur. The recursive means associated with the four chains are plotted in
Figure 6. They exhibit two limit points, corresponding to the two posterior
modes. While each chain appears to be stable, it only explores the posterior
in the neighborhood of one of the modes.
We explored various modiﬁcations of the RWM algorithm by changing
the scaling factor c and by setting the offdiagonal elements of
¯
l to zero.
Nevertheless, 1,000,000 draws were insufﬁcient for the chains initialized
at the low mode to cross over to the neighborhood of the high mode.
Two remarks are in order. First, extremum estimators that are computed
with numerical optimization methods suffer from the same problem as
FIGURE 6 Recursive means from multiple chains – Model
2
(L), Data
(
L). Each line corresponds
to recursive means (as a function of the number of draws) calculated from one of the four Markov
chains generated by the metropolis algorithm.
140 S. An and F. Schorfheide
the Bayes estimators in this example. One might ﬁnd a local rather than
the global extremum of the objective function. Hence, it is good practice
to start the optimization from different points in the parameter space
to increase the likelihood that the global optimum is found. Similarly,
in Bayesian computation it is helpful to start MCMC methods from
different regions of the parameter space, or vary the distribution q(0)
in the importance sampler. Second, in many applications as well as in
this example there exists a global mode that dominates the local modes.
Hence an exploration of the posterior in the neighborhood of the global
mode might still provide a good approximation to the overall posterior
distribution. All subsequent computations are based on the output gap rule
speciﬁcation of the DSGE model.
4.4. Parameter Transformations for
1
(L)/
1
(L)
Macroeconomists are often interested in posterior distributions of
parameter transformations h(0) to address questions such as what fraction
of the variation in output growth is caused by monetary policy shocks, and
what happens to output and inﬂation in response to a monetary policy
shock. Answers can be obtained from the moving average representation
associated with the state space model composed of (33) and (38). We will
focus on variance decompositions in the remainder of this subsection.
Fluctuations of output growth, inﬂation, and nominal interest rate
in the DSGE model are due to three shocks: technology growth shocks,
government spending shocks, and monetary policy shocks. Hence variance
decompositions of the endogenous variables lie in a threedimensional
simplex, which can be depicted as a triangle in
2
. In Figure 7 we plot
200 draws from the prior distribution (left panels) and 200 draws from the
posterior (right panels) of the variance decompositions of output growth
and inﬂation. The posterior draws are obtained by converting every 5,000th
draw generated with the RWM algorithm. The corners Z, G, and R of the
triangles correspond to decompositions in which the shocks e
z
, e
g
, and e
R
explain 100% of the variation, respectively.
Panels (1,1) and (2,1) indicate that the prior distribution of the
variance decomposition is informative in the sense that it is not uniform
over the simplex. For instance, the output gap policy rule speciﬁcation
1
implies that the government spending shock does not affect inﬂation and
nominal interest rates. Hence all prior and posterior draws concentrate on
the R −Z edge of the simplex. While the prior mean of the fraction of
inﬂation variability explained by the monetary policy shock is about 40%,
a 90% probability interval ranges from 0 to 95%. A priori about 10% of
the variation in output growth is due to monetary policy shocks. A 90%
probability interval ranges from 0 to 20%. The data provide additional
information about the variance decomposition. The posterior distribution
Bayesian Analysis of DSGE Models 141
FIGURE 7 Prior and posterior variance decompositions – Model
1
(L), Data
1
(L). The panels
depict 200 draws from prior and posterior distributions arranged on a 3dimensional simplex. The
three corners (Z,G,R) correspond to 100% of the variation being due to the shocks e
z,t
, e
g ,t
, and
e
R,t
, respectively.
is much more concentrated than the prior. The probability interval for
the contribution of monetary policy shocks to output growth ﬂuctuations
shrinks to the range from 1 to 4.5%. The posterior probability interval for
the fraction of inﬂation variability explained by the monetary policy shock
ranges from 15 to 37%.
4.5. Empirical Applications
There is a rapidly growing empirical literature on the Bayesian
estimation of DSGE models that applies the techniques described in
this paper. The following incomplete list of references aims to give an
overview of this work. Preceding the Bayesian literature are papers that
use maximum likelihood techniques to estimate DSGE models. Altug
(1989) estimates Kydland and Prescott’s (1982) timetobuild model, and
McGrattan (1994) studies the macroeconomic effects of taxation in an
estimated business cycle model. Leeper and Sims (1994) and Kim (2000)
estimated DSGE models that are usable for monetary policy analysis.
Canova (1994), DeJong et al. (1996), and Geweke (1999a) proposed
Bayesian approaches to calibration that do not exploit the likelihood
function of the DSGE model and provide empirical applications that assess
business cycle and asset pricing implications of simple stochastic growth
142 S. An and F. Schorfheide
models. The literature on likelihoodbased Bayesian estimation of DSGE
models began with work by LandonLane (1998), DeJong et al. (2000),
Schorfheide (2000), and Otrok (2001). DeJong et al. (2000) estimate a
stochastic growth model and examine its forecasting performance, Otrok
(2001) ﬁts a real business cycle with habit formation and timetobuild to
the data to assess the welfare costs of business cycles, and Schorfheide
(2000) considers cashinadvance monetary DSGE models. DeJong and
Ingram (2001) study the cyclical behavior of skill accumulation, whereas
Chang et al. (2002) estimate a stochastic growth model augmented with a
learningbydoing mechanism to amplify the propagation of shocks. Chang
and Schorfheide (2003) study the importance of labor supply shocks
and estimate a homeproduction model. FernándezVillaverde and Rubio
Ramírez (2004) use Bayesian estimation techniques to ﬁt a cattle–cycle
model to the data.
Variants of the smallscale New Keynesian DSGE model presented in
Section 2 have been estimated by Rabanal and RubioRamírez (2005a,b)
for the U.S. and the Euro Area. Lubik and Schorfheide (2004) estimate the
benchmark New Keynesian DSGE model without restricting the parameters
to the determinacy region of the parameter space. Schorfheide (2005)
allows for regimeswitching of the target inﬂation level in the monetary
policy rule. Canova (2004) estimates a smallscale New Keynesian model
recursively to assess the stability of the structural parameters over time.
Galí and Rabanal (2005) use an estimated DSGE model to study the effect
of technology shocks on hours worked. Largescale models that include
capital accumulation and additional real and nominal frictions along the
lines of Christiano et al. (2005) have been analyzed by Smets and Wouters
(2003, 2005) both for the U.S. and the Euro Area. Models similar to Smets
and Wouters (2003) have been estimated by Laforte (2004), Onatski and
Williams (2004), and Levin et al. (2006) to study monetary policy. Many
central banks are in the process of developing DSGE models along the
lines of Smets and Wouters (2003) that can be estimated with Bayesian
techniques and used for policy analysis and forecasting.
Bayesian estimation techniques have also been used in the open
economy literature. Lubik and Schorfheide (2003) estimate the small
open economy extension of the model presented in Section 2 to examine
whether the central banks of Australia, Canada, England, and New Zealand
respond to exchange rates. A similar model is ﬁtted by Del Negro (2003) to
Mexican data. Justiniano and Preston (2004) extend the empirical analysis
to situations of imperfect exchange rate passthrough. Adolfson et al.
(2004) analyze an open economy model that includes capital accumulation
as well as numerous real and nominal frictions. Lubik and Schorfheide
(2006), Rabanal and Tuesta (2006), and de Walque and Wouters (2004)
have estimated multicountry DSGE models.
Bayesian Analysis of DSGE Models 143
5. Model Evaluation
In Section 4 we discussed the estimation of a linearized DSGE model
and reported results on the posterior distribution of the model parameters
and variance decompositions. We tacitly assumed that model and prior
provide an adequate probabilistic representation of the uncertainty with
respect to data and parameters. This section studies various techniques that
can be used to evaluate the model ﬁt. We will distinguish the assessment of
absolute ﬁt from techniques that aim to determine the ﬁt of a DSGE model
relative to some other model. The ﬁrst approach can be implemented
by a posterior predictive model check and has the ﬂavor of a classical
hypothesis test. Relative model comparisons, on the other hand, are
typically conducted by enlarging the model space and applying Bayesian
inference and decision theory to the extended model space. Section 5.1
discusses Bayesian model checks, Section 5.2 reviews model posterior odds
comparisons, and Section 5.3 describes a more elaborate model evaluation
based on comparisons between DSGE models and VARs.
5.1. Posterior Predictive Checks
Predictive checks as a tool to assess the absolute ﬁt of a probability
model have been advocated, for instance, by Box (1980). A probability
model is considered as discredited by the data if one observes an
event that is deemed very unlikely by the model. Such model checks
are controversial from a Bayesian perspective. Methods that determine
whether actual data lie in the tail of a model’s data distribution potentially
favor alternatives that make unreasonably diffuse predictions. Nevertheless,
posterior predictive checks have become a valuable tool in applied
Bayesian analysis though they have not been used much in the context of
DSGE models. An introduction to Bayesian model checking can be found,
for instance, in books by Gelman et al. (1995), Lancaster (2004), and
Geweke (2005).
Let Y
rep
be a sample of observations of length T that we could
have observed in the past or that we might observe in the future. We
can derive the predictive distribution of Y
rep
given the current state of
knowledge:
p(Y
rep
 Y ) =
_
p(Y
rep
 0)p(0  Y )d0. (44)
Let h(Y ) be a test quantity that reﬂects an aspect of the data that we
want to examine. A quantitative model check can be based on Bayesian
pvalues. Suppose that the test quantity is univariate, nonnegative, and
has a unimodal density. Then one could compute probability of the tail
144 S. An and F. Schorfheide
event by
_
]h(Y
rep
) ≥ h(Y )]p(Y
rep
 Y )dY
rep
, (45)
where ]x ≥ a] is the indicator function that is 1 if x ≥ : and zero
otherwise. A small tail probability can be viewed as evidence against model
adequacy.
Rather than constructing numerical approximations of the tail
probabilities for univariate functions h(·), we use a graphical approach to
illustrate the model checking procedure in the context of model
1
(L). We
use the following data transformations: the correlation between inﬂation
and lagged interest rates, lagged inﬂation and current interest rates,
output growth and lagged output growth, and output growth and interest
rates. To obtain draws from the posterior predictive distribution of h(Y
rep
)
we take every 5,000th parameter draw of 0
(s)
generated with the RWM
algorithm, simulate a sample Y
rep
of 80 observations
9
from the DSGE model
conditional on 0
(s)
, and calculate h(Y
rep
).
We consider two cases: in the case of no misspeciﬁcation, depicted in
the left panels of Figure 8, the posterior is constructed based on data set
1
(L), whereas under misspeciﬁcation, illustrated in the two right panels
of Figure 8, the posterior is obtained from data set
5
(L). Each panel
of the ﬁgure depicts 200 draws from the posterior predictive distribution
in bivariate scatter plots. Moreover, the intersections of the solid lines
indicate the actual values h(Y ). Since
1
(L) was generated from model
1
(L), whereas
5
(L) was not, we would expect the actual values of h(Y )
to lie further in the tails of the posterior predictive distribution in the
right panels than in the left panels. Indeed a visual inspection of the plots
provides some evidence in which dimensions
1
(L) is at odds with data
generated from a model that includes lags of output in the household’s
Euler equation. The observed autocorrelation of output growth in
5
(L) is
much larger and the actual correlation between output growth and interest
rates is much lower than the draws generated from the posterior predictive
distribution.
5.2. Posterior Odds Comparisons of DSGE Models
The Bayesian framework is naturally geared toward the evaluation
of relative model ﬁt. Researchers can place probabilities on competing
models and assess alternative speciﬁcations based on their posterior odds.
An excellent survey on model comparisons based on posterior probabilities
9
To obtain draws from the unconditional distribution of y
t
we initialize s
0
= 0 and generate
180 observations, discarding the ﬁrst 100.
Bayesian Analysis of DSGE Models 145
FIGURE 8 Posterior predictive check for Model
1
(L). We plot 200 draws from the posterior
predictive distribution of various sample moments. Intersections of solid lines signify the observed
sample moments.
can be found in Kass and Rafterty (1995). For concreteness, suppose in
addition to the speciﬁcation
1
(L) we consider a version of the New
Keynesian model, denoted by
3
(L) in which prices are nearly ﬂexible,
that is, « = 5. Moreover, there is a model
4
(L), according to which the
central bank does not respond to output at all and ç
2
= 0. If we are willing
to place prior probabilities ¬
i,0
on the three competing speciﬁcations then
posterior model probabilities can be computed by
¬
i,T
=
¬
i,0
p(Y 
i
)
j =1,3,4
¬
j ,0
p(Y 
j
)
, i = 1, 3, 4. (46)
The key object in the calculation of posterior probabilities is the marginal
data density p(Y 
i
), which is deﬁned in (39).
Posterior model probabilities can be used to weigh predictions from
different models. In many instances, researchers take a shortcut and
use posterior probabilities to justify the selection of a particular model
speciﬁcation. All subsequent analysis is then conditioned on the chosen
model. It is straightforward to verify that under a 0–1 loss function (the
loss attached to choosing the wrong model is one), the optimal decision
is to select the highest posterior probability model. This 0–1 loss function
is an attractive benchmark in situations in which the researcher believes
that all the important models are included in the analysis. However, even
in situations in which all the models under consideration are misspeciﬁed,
146 S. An and F. Schorfheide
the selection of the highest posterior probability model has some desirable
properties. It has been shown under various regularity conditions, e.g.,
Phillips (1996) and FernándezVillaverde and RubioRamírez (2004), that
posterior odds (or their large sample approximations) asymptotically favor
the DSGE model that is closest to the ‘true’ data generating process in the
KullbackLeibler sense. Moreover, since the logmarginal data density can
be rewritten as
lnp(Y  ) =
T
t =1
lnp(y
t
 Y
t −1
, )
=
T
t =1
ln
__
p(y
t
 Y
t −1
, 0, )p(0  Y
t −1
, )d0
_
, (47)
where lnp(Y  ) can be interpreted as a predictive score (Good,
1952) and the model comparison based on posterior odds captures the
relative onestepahead predictive performance. The practical difﬁculty
in implementing posterior odds comparisons is the computation of the
marginal data density. We will subsequently consider two numerical
approaches: Geweke’s (1999b) modiﬁed harmonic mean estimator and
Chib and Jeliazkov’s (2001) algorithm.
Harmonic mean estimators are based on the identity
1
p(Y )
=
_
f (0)
(0  Y )p(0)
p(0  Y )d0, (48)
where f (0) has the property that
_
f (0)d0 = 1 (see Gelfand and Dey,
1994). Conditional on the choice of f (0) an obvious estimator is
ˆ
p
G
(Y ) =
_
1
n
sim
n
sim
s=1
f (0
(s)
)
(0
(s)
 Y )p(0
(s)
)
_
−1
, (49)
where 0
(s)
is drawn from the posterior p(0  Y ). To make the numerical
approximation efﬁcient, f (0) should be chosen so that the summands are
of equal magnitude. Geweke (1999b) proposed to use the density of a
truncated multivariate normal distribution,
f (0) = t
−1
(2¬)
−d,2
 V
0

−1,2
exp
_
−0.5(0 −
¯
0)
V
−1
0
(0 −
¯
0)
_
×
_
(0 −
¯
0)
V
−1
0
(0 −
¯
0) ≤ F
−1
,
2
d
(t)
_
. (50)
Here
¯
0 and V
0
are the posterior mean and covariance matrix computed
from the output of the posterior simulator, d is the dimension of the
Bayesian Analysis of DSGE Models 147
parameter vector, F
,
2
d
is the cumulative density function of a ,
2
random
variable with d degrees of freedom, and t ∈ (0, 1). If the posterior of 0
is in fact normal then the summands in (49) are approximately constant.
Chib and Jeliazkov (2001) use the following equality as the basis for their
estimator of the marginal data density:
p(Y ) =
(0  Y )p(0)
p(0  Y )
. (51)
The equation is obtained by rearranging the Bayes theorem and has
to hold for all 0. While the numerator can be easily computed, the
denominator requires a numerical approximation. Thus,
ˆ
p
CS
(Y ) =
(
˜
0  Y )p(
˜
0)
ˆ
p(
˜
0  Y )
, (52)
where we replaced the generic 0 in (51) by the posterior mode
˜
0. Within
the RWM Algorithm denote the probability of moving from 0 to 6 by
:(0, 6  Y ) = min]1, r (0, 6  Y )], (53)
where r (0, 6  Y ) was in the description of the algorithm. Moreover, let
q(0,
˜
0  Y ) be the proposal density for the transition from 0 to
˜
0. Then the
posterior density at the mode can be approximated by
ˆ
p(
˜
0  Y ) =
1
n
sim
n
sim
s=1
:(0
(s)
,
˜
0  Y )q(0
(s)
,
˜
0  Y )
J
−1
J
j =1
:(
˜
0, 0
(j )
 Y )
, (54)
where ]0
(s)
]
n
sim
s=1
are sampled draws from the posterior distribution with the
RWM algorithm and ]0
(j )
]
J
j =1
are draws from q(
˜
0, 0  Y ) given the posterior
mode value
˜
0.
We ﬁrst use Geweke’s harmonic mean estimator to approximate
the marginal data density associated with
1
(L),
1
(L). The results are
summarized in Figure 9. We calculate marginal data densities recursively
(as a function of the number of MCMC draws) for the four chains that
were initialized at different starting values as discussed in Section 4. For
the output gap rule all four chains lead to estimates of around −196.7.
Figure 10 provides a comparison of Geweke’s versus Chib and Jeliazkov’s
approximation of the marginal data density for the output gap rule
speciﬁcation. A visual inspection of the plot suggests that both estimators
converge to the same limit point. However, the modiﬁed harmonic mean
estimator appears to be more reliable if the number of simulations is small.
148 S. An and F. Schorfheide
FIGURE 9 Data densities from multiple chains – Model
1
(L), Data
1
(L). For each Markov
chain, log marginal data densities are computed recursively with Geweke’s modiﬁed harmonic mean
estimator and plotted as a function of the number of draws.
FIGURE 10 Geweke vs. Chib–Jeliazkov data densities – Model
1
(L), Data
1
(L). Log marginal
data densities are computed recursively with Geweke’s modiﬁed harmonic mean estimator as well
as the Chib–Jeliazkov estimator and plotted as a function of the number of draws.
Bayesian Analysis of DSGE Models 149
TABLE 4 Log marginal data densities based on
1
(L)
Speciﬁcation lnp(Y  ) Bayes factor versus
1
(L)
Benchmark model
1
(L) −196.7 1.00
Model with nearly ﬂexible prices
3
(L) −245.6 exp[48.9]
No policy reaction to output
4
(L) −201.9 exp[5.2]
Notes: The log marginal data densities for the DSGE model speciﬁcations are
computed based on Geweke’s (1999a) modiﬁed harmonic mean estimator.
Based on data set
1
(L) we also estimate speciﬁcation
3
(L) in which
prices are nearly ﬂexible and speciﬁcation
4
(L) in which the central
bank does not respond to output. The model comparison results are
summarized in Table 4. The marginal data density associated with
3
(L)
is −245.6, which translates into a Bayes factor (ratio of posterior odds
to prior odds) of approximately e
49
in favor of
1
(L). Hence, data set
1
(L) provides very strong evidence against ﬂexible prices. Given the
fairly concentrated posterior of « depicted in Figure 1 this result is not
surprising. The marginal data density of model
4
(L) is equal to −201.9
and the Bayes factor of model
1
(L) versus model
4
(L) is ‘only’ e
5
. The
DSGE model implies that when actual output is close to the target ﬂexible
price output, inﬂation will also be close to its target value. Vice versa,
deviations of output from target coincide with deviations of inﬂation from
its target value. This mechanism makes it difﬁcult to identify the policy rule
coefﬁcients and imposing an incorrect value for ç
2
is not particularly costly
in terms of ﬁt.
5.3. Comparison of a DSGE Model with a VAR
The notion of potential misspeciﬁcation of a DSGE model can be
incorporated in the Bayesian framework by including a more general
reference model
0
into the model set. A natural choice of reference
model in dynamic macroeconomics is a VAR, as linearized DSGE models,
at least approximately, can be interpreted as restrictions on a VAR
representation. The ﬁrst step of the comparison is typically to compute
posterior probabilities for the DSGE model and the VAR, which can be
used to detect the presence of misspeciﬁcations. Since the VAR parameter
space is generally much larger than the DSGE model parameter space,
the speciﬁcation of a prior distribution for the VAR parameter requires
careful attention. Possible pitfalls are discussed in Sims (2003). A VAR with
a prior that is very diffuse is likely to be rejected even against a misspeciﬁed
DSGE model. In a more general context this phenomenon is often called
Lindley’s paradox. We will subsequently present a procedure that allows us
to document how the marginal data density of the DSGE model changes as
150 S. An and F. Schorfheide
the crosscoefﬁcient restrictions that the DSGE model imposes on the VAR
are relaxed.
If the data favor the VAR over the DSGE model then it becomes
important to investigate further the deﬁciencies of the structural model.
This can be achieved by comparing the posterior distributions of
interesting population characteristics such as impulse response functions
obtained from the DSGE model and from a VAR representation that does
not dogmatically impose the DSGE model restrictions. We will refer to
the latter benchmark model as DSGEVAR and discuss an identiﬁcation
scheme that allows us to construct structural impulse response functions
for the vector autoregressive speciﬁcation against which the DSGE model
can be evaluated. Building on work by Ingram and Whiteman (1994) the
DSGEVAR approach of Del Negro and Schorfheide (2004) was designed
to improve forecasting and monetary policy analysis with VARs. The
framework has been extended to a model evaluation tool in Del Negro
et al. (2006) and used to assess the ﬁt of a variant of the Smets and Wouters
(2003) model.
To construct a DSGEVAR we proceed as follows. Consider a vector
autoregressive speciﬁcation of the form
y
t
= 4
0
+4
1
y
t −1
+· · · +4
p
y
t −p
+u
t
, [u
t
u
t
] = l. (55)
Deﬁne the k ×1 vector x
t
= [1, y
t −1
, . . . , y
t −p
]
, the coefﬁcient matrix
4 = [4
0
, 4
1
, . . . , 4
p
]
, the T ×n matrices Y and U composed of rows y
t
and
u
t
, and the T ×k matrix X with rows x
t
. Thus the VAR can be written as
Y = X4 +U. Let
D
0
[·] be the expectation under DSGE model and deﬁne
the autocovariance matrices
!
XX
(0) =
D
0
[x
t
x
t
], !
XY
(0) =
D
0
[x
t
y
t
].
A VAR approximation of the DSGE model can be obtained from restriction
functions that relate the DSGE model parameters to the VAR parameters,
4
∗
(0) = !
−1
XX
(0)!
XY
(0), l
∗
(0) = !
YY
(0) −!
YX
(0)!
−1
XX
(0)!
XY
(0). (56)
This approximation is typically not exact because the state–space
representation of the linearized DSGE model generates moving average
terms. Its accuracy depends on the number of lags p, and the magnitude
of the roots of the moving average polynomial. We will document below
that four lags are sufﬁcient to generate a fairly precise approximation of
the model
1
(L).
10
10
In principle one could start from a VARMA model to avoid the approximation error. The
posterior computations, however, would become signiﬁcantly more cumbersome.
Bayesian Analysis of DSGE Models 151
In order to account for potential misspeciﬁcation of the DSGE model
it is assumed that there is a vector 0 and matrices 4
A
and l
A
such that the
data are generated from the VAR in (55) with the coefﬁcient matrices
4 = 4
∗
(0) +4
A
, l = l
∗
(0) +l
A
. (57)
The matrices 4
A
and l
A
capture deviations from the restriction functions
4
∗
(0) and l
∗
(0).
Bayesian analysis of this model requires the speciﬁcation of a prior
distribution for the DSGE model parameters, p(0), and the misspeciﬁcation
matrices. Rather than specifying a prior in terms of 4
A
and l
A
it is
convenient to specify it in terms of 4 and l conditional on 0. We assume
l 0 ∼ W
_
zTl
∗
(0), zT −k, n
_
(58)
4 l, 0 ∼
_
4
∗
(0),
1
zT
_
l
−1
⊗ !
XX
(0)
_
−1
_
,
where W denotes the inverted Wishart distribution.
11
The prior
distribution can be interpreted as a posterior calculated from a sample of
zT observations generated from the DSGE model with parameters 0; see
Del Negro and Schorfheide (2004). It has the property that its density is
approximately proportional to the Kullback–Leibler discrepancy between
the VAR approximation of the DSGE model and the 4l VAR, which is
emphasized in Del Negro et al. (2006). z is a hyperparameter that scales the
prior covariance matrix. The prior is diffuse for small values of z and shifts
its mass closer to the DSGE model restrictions as z −→∞. In the limit the
VAR is estimated subject to the restrictions (56). The prior distribution is
proper provided that zT ≥ k +n.
The joint posterior density of VAR and DSGE model parameters can be
conveniently factorized as
p
z
(4, l, 0  Y ) = p
z
(4, l Y , 0)p
z
(0  Y ). (59)
The zsubscript indicates the dependence of the posterior on the
hyperparameter. It is straightforward to show, e.g., Zeller (1971), that the
posterior distribution of 4 and l is also of the inverted Wishart normal
form:
l Y , 0 ∼ W
_
(1 +z)T
¨
l
b
(0), (1 +z)T −k, n
_
4 Y , l, 0 ∼
_
¨
4
b
(0), l ⊗ (zT!
XX
(0) +X
X)
−1
_
,
(60)
11
Ingram and Whiteman (1994) constructed a VAR prior from a stochastic growth model
to improve the forecast performance of the VAR. However, their setup did not allow for the
computation of a posterior distribution for 0.
152 S. An and F. Schorfheide
where
¨
4
b
(0) and
¨
l
b
(0) are the given by
¨
4
b
(0) =
_
z
1 +z
!
XX
(0) +
1
1 +z
X
X
T
_
−1
_
z
1 +z
!
XY
+
1
1 +z
X
Y
T
_
¨
l
b
(0) =
1
(1 +z)T
(zT!
YY
(0) +Y
Y ) −(zT!
YX
(0) +Y
X)
×(zT!
XX
(0) +X
X)
−1
(zT!
XY
(0) +X
Y )].
Hence the larger the weight z of the prior, the closer the posterior mean
of the VAR parameters is to 4
∗
(0) and l
∗
(0), the values that respect
the crossequation restrictions of the DSGE model. On the other hand,
if z = (n +k),T, then the posterior mean is close to the OLS estimate
(X
X)
−1
X
Y . The marginal posterior density of 0 can be obtained through
the marginal likelihood
p
z
(Y  0) =
zT!
XX
(0) +X
X
−
n
2
(1 +z)T
¨
l
b
(0)
−
(1+z)T−k
2
zT!
XX
(0)
−
n
2
zTl
∗
(0)
−
zT−k
2
×
(2¬)
−nT,2
2
n((1+z)T−k)
2
n
i=1
![((1 +z)T −k +1 −i),2]
2
n(zT−k)
2
n
i=1
![(zT −k +1 −i),2]
.
A derivation is provided in Del Negro and Schorfheide (2004). The paper
also shows that in large samples the resulting estimator of 0 can be
interpreted as a Bayesian minimum distance estimator that projects the
VAR coefﬁcient estimates onto the subspace generated by the restriction
functions (56).
Since the empirical performance of the DSGEVAR procedure crucially
depends on the weight placed on the DSGE model restrictions, it is
important to consider a datadriven procedure to determine z. A natural
criterion for the choice of z in a Bayesian framework is the marginal data
density
p
z
(Y ) =
_
p
z
(Y  0)p(0)d0. (61)
For computational reasons we restrict the hyperparameter to a ﬁnite grid
A. If one assigns equal prior probability to each grid point then the
normalized p
z
(Y )’s can be interpreted as posterior probabilities for z.
Del Negro et al. (2006) emphasize that the posterior of z provides a
measure of ﬁt for the DSGE model: high posterior probabilities for large
Bayesian Analysis of DSGE Models 153
values of z indicate that the model is well speciﬁed and a lot of weight
should be placed on its implied restrictions. Deﬁne
ˆ
z = argmax
z∈A
p
z
(Y ). (62)
If p
z
(Y ) peaks at an intermediate value of z, say between 0.5 and 2,
then a comparison between DSGEVAR(
ˆ
z) and DSGE model impulse
responses can yield important insights about the misspeciﬁcation of the
DSGE model.
An impulse response function comparison requires the identiﬁcation
of structural shocks in the context of the VAR. So far, the VAR given in (55)
has been speciﬁed in terms of reduced form disturbances u
t
. According to
the DSGE model, the onestepahead forecast errors u
t
are functions of the
structural shocks e
t
, which we represent by
u
t
= l
tr
De
t
. (63)
l
tr
is the Cholesky decomposition of l, and D is an orthonormal
matrix that is not identiﬁable based on the likelihood function associated
with (55). Del Negro and Schorfheide (2004) proposed to construct D as
follows. Let A
0
(0) be the contemporaneous impact of e
t
on y
t
according to
the DSGE model. Using a QR factorization, the initial response of y
t
to the
structural shocks can be can be uniquely decomposed into
_
cy
t
ce
t
_
DSGE
= A
0
(0) = l
∗
tr
(0)D
∗
(0), (64)
where l
∗
tr
(0) is lower triangular and D
∗
(0) is orthonormal. The initial
impact of e
t
on y
t
in the VAR, on the other hand, is given by
_
cy
t
ce
t
_
VAR
= l
tr
D. (65)
To identify the DSGEVAR, we maintain the triangularization of its
covariance matrix l and replace the rotation D in (65) with the function
D
∗
(0) that appears in (64). The rotation matrix is chosen so that in absence
of misspeciﬁcation the DSGE’s and the DSGEVAR’s impulse responses
to all shocks approximately coincide. To the extent that misspeciﬁcation
is mainly in the dynamics, as opposed to the covariance matrix of
innovations, the identiﬁcation procedure can be interpreted as matching,
at least qualitatively, the shortrun responses of the VAR with those from
the DSGE model. The estimation of the DSGEVAR can be implemented
as follows.
154 S. An and F. Schorfheide
MCMC Algorithm for DSGEVAR
1. Use the RWM algorithm to generate draws 0
(s)
from the marginal
posterior distribution p
z
(0  Y ).
2. Use Geweke’s modiﬁed harmonic mean estimator to obtain a numerical
approximation of p
z
(Y ).
3. For each draw 0
(s)
generate a pair 4
(s)
, l
(s)
, by sampling from the
W − distribution. Moreover, compute the orthonormal matrix
D
(s)
= D
∗
(0) as described above.
We now implement the DSGEVAR procedure for
1
(L) based on
artiﬁcially generated data. All the results reported subsequently are based
on a DSGEVAR with p = 4 lags. The ﬁrst step of our analysis is to construct
a posterior distribution for the parameter z. We assume that z lies on the
grid A = ].25, .5, .75, 1, 5, ∞] and assign equal probabilities to each grid
point. For z = ∞ the misspeciﬁcation matrices 4
A
and l
A
are zero and we
estimate the VAR by imposing the restrictions 4 = 4
∗
(0) and l = l
∗
(0).
Table 5 reports log marginal data densities for the DSGEVAR as a
function of z for data sets
1
(L) and
5
(L). The ﬁrst row reports the
marginal data density associated with the state space representation of
the DSGE model, whereas the second row corresponds to the DSGE
VAR(∞). If the VAR approximation of the DSGE model were exact, then
the values in the ﬁrst and second row of Table 5 would be identical. For
data set
1
(L), which has been directly generated from the state space
representation of
1
(L), the two values are indeed quite close. Moreover,
the marginal data densities are increasing as a function of z, indicating that
there is no evidence of misspeciﬁcation and that it is best to dogmatically
impose the DSGE model restrictions.
With respect to data set
5
(L) the DSGE model is misspeciﬁed. This
misspeciﬁcation is captured in the inverse Ushape of the marginal data
density function, which is representative for the shapes found in empirical
applications in Del Negro and Schorfheide (2004) and Del Negro et al.
(2006). The value z = 1.00 has the highest likelihood. The marginal data
TABLE 5 Log marginal data densities for
1
(L) DSGEVARs
Speciﬁcation
1
(L)
5
(L)
DSGE Model −196.66 −245.62
DSGEVAR z = ∞ −196.88 −244.54
DSGEVAR z = 5.00 −198.87 −241.95
DSGEVAR z = 1.00 −206.57 −238.59
DSGEVAR z = .75 −209.53 −239.40
DSGEVAR z = .50 −215.06 −241.81
DSGEVAR z = .25 −231.20 −253.61
Notes: See Table 4.
Bayesian Analysis of DSGE Models 155
densities drop substantially for z ≥ 5 and z ≤ 0.5. In order to assess the
nature of the misspeciﬁcation for
5
(L) we now turn to the impulse
response function comparison.
In principle, there are three different sets of impulse responses to
be compared: responses from the state–space representation of the DSGE
model, the z = ∞ and the z =
ˆ
z DSGEVAR. Moreover, these impulse
responses can either be compared based on the same parameter values
0 or their respective posterior estimates of the DSGE model parameters.
Figure 11 depicts posterior mean impulse responses for the state–space
representation of the DSGE model as well as the DSGEVAR(∞). In both
FIGURE 11 Impulse responses, DSGE, and DSGEVAR(z = ∞) – Model
1
(L), Data
5
(L).
DSGE model responses computed from state–space representation: posterior mean (solid); DSGE
VAR(z = ∞) responses: posterior mean (dashed) and pointwise 90% probability bands (dotted).
156 S. An and F. Schorfheide
cases we use the same posterior distribution of 0, namely, the one obtained
from the DSGEVAR(∞). The discrepancy between the posterior mean
responses (solid and dashed lines) indicates the magnitude of the error
that is made by approximating the state–space representation of the DSGE
model by a fourthorder VAR. Except for the response of output to the
government spending shock, the DSGE and DSGEVAR(∞) responses are
virtually indistinguishable, indicating that the approximation error is small.
The (dotted) bands in Figure 11 depict pointwise 90% probability intervals
for the DSGEVAR(∞) and reﬂect posterior parameter uncertainty with
respect to 0.
To assess the misspeciﬁcation of the DSGE model we compare posterior
mean responses of the z = ∞ (dashed) and
ˆ
z (solid) DSGEVAR in
Figure 12. Both sets of responses are constructed from the
ˆ
z posterior
of 0. The (dotted) 90% probability bands reﬂect uncertainty with respect
to the discrepancy between the z = ∞and
ˆ
z responses. A brief description
of the computation can clarify the interpretation. For each draw of 0
from the
ˆ
z DSGEVAR posterior we compute the
ˆ
z and the z = ∞
response functions, calculate their differences, and construct probability
intervals of the differences. To obtain the dotted bands in the ﬁgure,
we take the upper and lower bound of these probability intervals and
shift them according to the posterior mean of the z = ∞ response.
Roughly speaking, the ﬁgure answers the question: to what extent do the
ˆ
z
estimates of the VAR coefﬁcients deviate from the DSGE model restriction
functions 4
∗
(0) and l
∗
(0). The discrepancy, however, is transformed from
the 4–l space into impulse response functions because they are easier
to interpret.
While the relaxation of the DSGE model restrictions has little effect on
the propagation of the technology shock, the inﬂation and interest rate
responses to a monetary policy shock are markedly different. According to
the VAR approximation of the DSGE model, inﬂation returns quickly to
its steadystate level after a contractionary policy shock. The DSGEVAR(
ˆ
z)
response of inﬂation, on the other hand, has a slight hump shape, and the
reversion to the steadystate is much slower. Unlike in the DSGEVAR(∞),
the interest rate falls below steadystate in period four and stays negative
for several periods.
In a general equilibrium model a misspeciﬁcation of the households’
decision problem can have effects on the dynamics of all the endogenous
variables. Rather than looking at the dynamic responses of the endogenous
variables to the structural shocks, we can also ask to what extent are the
optimality conditions that the DSGE model imposes satisﬁed by the DSGE
VAR(
ˆ
z) responses. According to the loglinearized DSGE model output,
inﬂation, and interest rates satisfy the following relationships in response
Bayesian Analysis of DSGE Models 157
FIGURE 12 Impulse responses, DSGEVAR(z = ∞), and DSGEVAR(z = 1) – Model
1
(L), Data
5
(L). DSGEVAR(z = ∞) posterior mean responses (dashed), DSGEVAR(z = 1) posterior mean
responses (solid). Pointwise 90% probability bands (dotted) signify shifted probability intervals for
the difference between z = ∞ and z = 1 responses.
to the shock e
R,t
:
0 = ˆ y
t
−
¨
t
[y
t +1
] +
1
t
(
¨
R
t
−
¨
t
[¬
t +1
]) (66)
0 = ˆ ¬
t
−[
t
[ ˆ ¬
t +1
] −«ˆ y
t
(67)
e
R,t
=
¨
R
t
−j
R
¨
R
t −1
−(1 −j
R
)ç
1
ˆ ¬
t
−(1 −j
R
)ç
2
ˆ y
t
(68)
Figure 13 depicts the path of the righthand side of Equations (66) to (68)
in response to a monetary policy shock. Based on draws from the joint
posterior of the DSGE and VAR parameters we can ﬁrst calculate identiﬁed
158 S. An and F. Schorfheide
FIGURE 13 Impulse responses, DSGEVAR(z = ∞), and DSGEVAR(z = 1) – Model
1
(L), Data
5
(L). DSGE model responses: posterior mean (dashed); DSGEVAR responses: posterior mean
(solid) and pointwise 90% probability bands (dotted).
VAR responses to obtain the path of output, inﬂation, and interest rate,
and in a second step use the DSGE model parameters to calculate the
wedges in the Euler equation, the price setting equation, and the monetary
policy rule. The dashed lines show the posterior mean responses according
to the state–space representation of the DSGE model, and the solid lines
depict DSGEVAR responses. The top three panels of Figure 13 show that
both for the DSGE model as well as the DSGEVAR(∞) the three equations
are satisﬁed. The bottom three panels of the ﬁgure are based on the DSGE
VAR(
ˆ
z), which relaxes the DSGE model restrictions. While the price setting
relationship and the monetary policy rule restriction seem to be satisﬁed,
at least for the posterior mean, Panel (2,1) indicates a substantial violation
of the consumption Euler equation. This ﬁnding is encouraging for the
evaluation strategy since the data set
5
(L) was indeed generated from a
model with a modiﬁed Euler equation.
While this section focused mostly on the assessment of a single DSGE
model, Del Negro et al. (2006) use the DSGEVAR framework also to
compare multiple DSGE models. Schorfheide (2000) proposed a loss
functionbased evaluation framework for (multiple) DSGE models that
Bayesian Analysis of DSGE Models 159
augments potentially misspeciﬁed DSGE models with a more general
reference model, constructs a posterior distribution for population
characteristics of interest such as autocovariances and impulse responses,
and then examines the ability of the DSGE models to predict the
population characteristics. This prediction is evaluated under a loss
function and the risk is calculated under an overall posterior distribution
that averages the predictions of the DSGE models and the reference
model according to their posterior probabilities. This lossfunctionbased
approach nests DSGE model comparisons based on marginal data densities
as well as assessments based on a comparison of model moments to sample
moments, popularized in the calibration literature, as special cases.
6. NONLINEAR METHODS
For a nonlinear/nonnormal state–space model, the linear Kalman
ﬁlter cannot be used to compute the likelihood function. Instead,
numerical methods have to be used to integrate the latent state vector. The
evaluation of the likelihood function can be implemented with a particle
ﬁlter, also known as a sequential Monte Carlo ﬁlter. Gordon et al. (1993)
and Kitagawa (1996) are early contributors to this literature. Arulampalam
et al. (2002) provide an excellent survey. In economics, the particle ﬁlter
has been applied to analyze the stochastic volatility models by Pitt and
Shephard (1999) and Kim et al. (1998). Recently FernándezVillaverde
and RubioRamírez (2005) use the ﬁlter to construct the likelihood for
DSGE model solved with a projection method. We follow their approach
and use the particle ﬁlter for DSGE model
1
solved with a secondorder
perturbation method. A brief description of the procedure is given below.
We use Y
t
to denote the t ×n matrix with rows y
t
, t = 1, . . . , t. The vector
s
t
has been deﬁned in Section 2.4.
Particle Filter
1) Initialization: Draw N particles s
i
0
, i = 1, . . . , N, from the initial
distribution p(s
0
 0). By induction, in period t we start with the particles
_
s
i
t −1
_
N
i=1
, which approximate p
_
s
t −1
 Y
t −1
, 0
_
.
2) Prediction: Draw onestepahead forecasted particles
_
˜ s
i
t
_
N
i=1
from
p
_
s
t
 Y
t −1
, 0
_
. Note that
p
_
s
t
 Y
t −1
, 0
_
=
_
p (s
t
 s
t −1
, 0) p
_
s
t −1
 Y
t −1
, 0
_
ds
t −1
≈
1
N
N
i=1
p
_
s
t
 s
i
t −1
, 0
_
.
Hence one can draw N particles from p
_
s
t
 Y
t −1
, 0
_
by generating one
particle from p
_
s
t
 s
i
t −1
, 0
_
for each i.
160 S. An and F. Schorfheide
3) Filtering: The goal is to approximate
p
_
s
t
 Y
t
, 0
_
=
p
_
y
t
 s
t
, 0
_
p
_
s
t
 Y
t −1
, 0
_
p
_
y
t
 Y
t −1
, 0
_ , (69)
which amounts to updating the probability weights assigned to the particles
_
˜ s
i
t
_
N
i=1
. We begin by computing the nonnormalized importance weights
˜ ¬
i
t
= p
_
y
t
 ˜ s
i
t
, 0
_
. The denominator in (69) can be approximated by
p
_
y
t
 Y
t −1
, 0
_
=
_
p
_
y
t
 s
t
, 0
_
p
_
s
t
 Y
t −1
, 0
_
ds
t
≈
1
N
N
i=1
˜ ¬
i
t
. (70)
Now deﬁne the normalized weights
¬
i
t
=
˜ ¬
i
t
N
j =1
˜ ¬
j
t
and note that the importance sampler
_
˜ s
i
t
, ¬
i
t
_
N
i=1
approximates
12
the
updated density p
_
s
t
 Y
t
, 0
_
.
4) Resampling: We now generate a new set of particles
_
s
i
t
_
N
i=1
by
resampling with replacement N times from an approximate discrete
representation of p
_
s
t
 Y
t
, 0
_
given by
_
˜ s
i
t
, ¬
i
t
_
N
i=1
so that
Pr
_
s
i
t
= ˜ s
i
t
_
= ¬
i
t
, i = 1, . . . , N.
The resulting sample is in fact an iid sample from the discretized density of
p(s
t
 Y
t
, 0) and hence is equally weighted.
5) Likelihood Evaluation: According to (70) the log likelihood function
can be approximated by
ln(0  Y
T
) = ln p(y
1
 0) +
T
t =2
lnp
_
y
t
 Y
t −1
, 0
_
≈
N
t =1
_
1
N
N
i=1
˜ ¬
i
t
_
.
To compare results from ﬁrst and secondorder accurate DSGE model
solutions we simulated artiﬁcial data of 80 observations from the quadratic
approximation of model
1
with parameter values reported in Table 3
under the heading
1
(Q). In the remainder of this section we will refer
to these parameters as “true” values as opposed to “pseudotrue” values to
12
The sequential importance sampler (SIS) is a Monte Carlo method which utilized this aspect,
but it is well documented that it suffers from a degeneracy problem, where after a few iterations,
all but one particle will have negligible weight.
Bayesian Analysis of DSGE Models 161
be deﬁned later. These true parameter values by and large resemble the
parameter values that have been used to generate data from the loglinear
DSGE model speciﬁcations. However, there are some exceptions. The
degree of imperfect competition, v, is set to 0.1, which implies a steadystate
markup of 11% that is consistent with the estimates of Basu (1995). 1,g
is chosen as .85, which implies that the steadystate consumption amounts
to 85% of output. The slope coefﬁcient of the Phillips curve, «, is chosen
to be .33, which implies less price stickiness than in the linear case. The
implied quadratic adjustment cost coefﬁcient, [, is 53.68. We also make
monetary policy less responsive to the output gap by setting ç
2
= .125. ¸
(Q)
,
r
(A)
, and ¬
(A)
are chosen as .55, 1.0, and 3.2 to match the average output
growth rate, interest rate, and inﬂation between the artiﬁcial data and the
real U.S. data. These values are different from the mean of the historical
observations because in the nonlinear version of the DSGE model means
differ from steady states. Other exogenous process parameters, j
g
, j
z
, o
R
,
o
g
, and o
z
, are chosen so that the second moments are matched to the U.S.
data. For computational convenience, a measurement error is introduced
to each measurement equation, whose standard deviation is set as 20% of
that of each observation.
13
6.1. Conﬁguration of the Particle Filter
There are several issues concerning the practical implementation of
the particle ﬁlter. First, we need a scheme to draw from the initial state
distribution, p (s
0
 0). In the linear case, it is straightforward to calculate the
unconditional distribution of s
t
associated with the vector autoregressive
representation (33). For the secondorder approximation we rewrite the
state transition equation (37) as follows. Decompose s
t
= [x
t
, ¸
t
]
, where ¸
t
is composed of the exogenous processes e
R,t
, ˆ g
t
, and ˆ z
t
. The law of motion
for the endogenous state variables x
j ,t
can be expressed as
x
j ,t
= +
(0)
j
++
(1)
j
w
t
+w
t
+
(2)
j
w
t
(71)
where w
t
= [x
t −1
, ¸
t
]
. We generate x
0
by drawing ¸
0
from its unconditional
distribution (the law of motion for ¸
t
is linear) and setting x
−1
= x, where
x is the steadystate of x
t
.
Second, we have to choose the number of particles. For a good
approximation of the prediction error distribution, it is desirable to
have many particles, especially enough particles to capture the tails of
13
Without the measurement error two complications arise: since p(y
t
 s
t
) degenerates to a point
mass and the distribution of s
t
is that of a multivariate noncentral ,
2
the evaluation of p(y
t
 Y
t −1
)
becomes difﬁcult. Moreover, the computation of p(s
t
 Y
t
) requires the solution of a system of
quadratic equations.
162 S. An and F. Schorfheide
p(s
t
 Y
t
). Moreover, the number of particles affects the performance
of the resampling algorithm. If the number of particles is too small,
the resampling will not work well. In our implementation, the stratiﬁed
resampling scheme proposed by Kitagawa (1996) is applied. It is optimal
in terms of variance in the class of unbiased resampling schemes. If the
measurement errors in the conditional distribution p(y
t
 s
t
) are small,
more particles are needed to obtain an accurate approximation of the
likelihood function and to ensure that the posterior weights ¬
i
t
do not
assign probability one to a single particle. In our application, we found
that 40,000 particles were enough to get stable evalutaions of the likelihood
given the size of the measurement errors.
Even though the estimation procedure involves extensive random
sampling, the particle ﬁlter can be readily implemented on a good desktop
computer. We implement most of the procedure in MATLAB (2005) so
that we can exploit the symbolic toolbox to solve the DSGE model, but it
takes too much time to evaluate the likelihood function using the particle
ﬁlter. The ﬁltering step is implemented as FORTRAN mex library, so we
can call it as a function in MATLAB. Based on a sample of 80 observations
we can generate 1,000 draws with 40,000 particles in 1 h and 40 min (6.0 sec
per draw) on the AMD64 3000+ machine with 1 GB RAM. Linear methods
are more than 200 times faster: 1,000 draws are generated in 24 sec in our
Matlab routines and 3 sec in our GAUSS routines.
6.2. A Look at the Likelihood Function
We will begin our analysis by studying proﬁles of likelihood functions.
For brevity, we will refer to the likelihood obtained from the ﬁrstorder
(secondorder) accurate solution of the DSGE model as linear (quadratic)
likelihood. It is natural to evaluate the quadratic likelihood function in the
neighborhood of the true parameter values given in Table 3. However, we
evaluate the linear likelihood around the pseudotrue parameter values,
which are obtained by ﬁnding the mode of the linear likelihood using
3,000 observations. The parameter values for v and 1,g are ﬁxed at their
true values because they do not enter the linear likelihood. Recall that we
had introduced a reducedform Phillips curve parameter « in (32) because
v and [ cannot be identiﬁed with the loglinearized DSGE model.
Figure 14 shows the loglikelihood proﬁles along each structural
parameter dimension. Two features are noticeable in this comparison.
First, the quadratic loglikelihood peaks around the true parameter values,
while the linear loglikelihood attains its maximum around the pseudotrue
parameter values. The differences between the peaks are most pronounced
for the steadystate parameters r
(A)
and ¬
(A)
. While in the linearized
model steady states and longrun averages coincide, they differ if the
model is solved by a secondorder approximation. For some parameters
Bayesian Analysis of DSGE Models 163
FIGURE 14 Linear vs. quadratic approximations: likelihood proﬁles. Data Set
1
(Q). Likelihood
proﬁle for each parameter:
1
(L)/Kalman ﬁlter (dashed) and
1
(Q)/particle ﬁlter (solid). 40,000
particles are used. Vertical lines signify true (dotted) and pseudotrue (dasheddotted) values.
164 S. An and F. Schorfheide
FIGURE 15 Linear vs. quadratic approximations: Likelihood contours. Data set
1
(Q). Contours
of likelihood (solid) for
1
(L) and
1
(Q). 40,000 particles are used. Large dot indicates true and
pseudotrue parameter value. « is constant along dashed lines.
the quadratic loglikelihood function is more concave than the linear
one, which implies that the nonlinear approach is able to extract more
information on the structural parameters from the data. For instance,
it appears that the monetary policy parameter such as ç
1
can be more
precisely estimated with the quadratic approximation.
As noted before, the quadratic approximation can identify some
structural parameters that are unidentiﬁable under the loglinearized
model. g does not enter the linear version of the model and hence
the loglikelihood proﬁle along this dimension is ﬂat. In the quadratic
approximation, however, the loglikelihood is slightly sloped in 1,g = c,y
dimension. Moreover, the linear likelihood is ﬂat for the values of v and
[ that imply a constant «. This is illustrated in Figure 15, which depicts
the linear and quadratic likelihood contours in v[ space. The contours
of the linear likelihood trace out iso« lines. The right panel of Figure 15
indicates that the iso« lines intersect with the contours of the quadratic
likelihood function, which suggests that v and [ are potentially separately
identiﬁable. However, our sample of 80 observations is too short to obtain
a sharp estimate of the two parameters.
6.3. The Posterior
We now compare the posterior distributions obtained from the linear
and nonlinear analysis. In both cases we use the same prior distribution
reported in Table 3. Unlike in the analysis of the likelihood function we
now substitute the adjustment cost parameter [ with the Phillipscurve
parameter « in the quadratic approximation of the DSGE model. A beta
prior with mean .1 and standard deviation 0.05 is placed on v, which
Bayesian Analysis of DSGE Models 165
roughly covers micro evidences of 10–15% markup. Note that 1 −1,g is
the steadystate government spending–output ratio, and hence a beta prior
with mean 0.85 and standard deviation .1 is used for 1,g .
We use the RWM algorithm to generate draws from the posterior
distributions associated with the linear and quadratic approximations of
the DSGE model. We ﬁrst compute the posterior mode for the linear
speciﬁcation with the additional parameters, v and 1,g , ﬁxed at their true
values. After that, we evaluate the Hessian to be used in the RWM algorithm
at the (linear) mode without ﬁxing v and 1,g , so that the inverse Hessian
reﬂects the prior variance of the additional parameters. This Hessian is
used for both the linear and the nonlinear analysis. We use scaling factors
.5 (linear) and .25 (quadratic) to target an acceptance rate of about 30%.
The Markov chains are initialized in the neighborhood of the pseudotrue
and true parameter values, respectively.
Figures 16 and 17 depict the draws from prior, linear posterior, and
quadratic posterior distribution. 100,000 draws from each distribution are
generated and every 500th draw is plotted. The draws tend to be more
concentrated as we move from prior to posterior. While, for most of our
parameters, linear and quadratic posteriors are quite similar, there are a
few exceptions. The quadratic posterior mean of ç
1
is larger than the
linear posterior mean and closer to the true value. The quadratic posterior
means for the steadystate parameters r
(A)
and ¬
(A)
are also greater than the
corresponding linear posterior means, which is consistent with the positive
difference between “true” and “pseudotrue” values of these parameters.
Now consider the parameter v that determines the demand elasticity
for the differentiated products. Conditional on « this parameter is not
identiﬁable under the linear approximation and hence its posterior is
not updated. The parameter does, however, affect the secondorder terms
that arise in the quadratic approximation of the DSGE model. Indeed,
the quadratic posterior of v is markedly different from the prior as it
concentrates around 0.05. Moreover, there is a clear negative correlation
between « and v according to the quadratic posterior.
Table 6 reports the log marginal data densities for our linear (
1
(L))
and quadratic (
1
(Q)) approximations of the DSGE model based on
Data Set
1
(Q). The log marginal likelihoods are −416.06 for
1
(L)
and −408.09 for
1
(Q), which imply a Bayes factor of about e
8
in favor
of the quadratic approximation. This result suggests that
1
(Q) exhibits
nonlinearities that can be detected by the likelihoodbased estimation
methods. Our simulation results with respect to linear versus nonlinear
estimation are in line with the ﬁndings reported in FernándezVillaverde
and RubioRamírez (2005) for a version of the neoclassical stochastic
growth model. In their analysis the nonlinear solution combined with
the particle ﬁlter delivers a substantially better ﬁt of the model to the
data as measured by the marginal data density, both for simulated as well
166 S. An and F. Schorfheide
FIGURE 16 Posterior draws: linear vs. quadratic approximation I. Data set
1
(Q). 100,000 draws
from the prior and posterior distributions. Every 500th draw is plotted. Intersections of solid and
dotted lines signify true and pseudotrue parameter values. 40,000 particles are used.
Bayesian Analysis of DSGE Models 167
FIGURE 17 Posterior draws: Linear vs. quadratic approximation II. See Figure 16.
168 S. An and F. Schorfheide
TABLE 6 Log marginal data densities based on
1
(Q)
Speciﬁcation lnp(Y 
1
) Bayes factor vesus
1
(Q)
Benchmark model, linear solution
1
(L) −416.06 exp[7.97]
Benchmark model, quadratic solution
1
(Q) −408.09 1.00
Notes: See Table 4.
as actual data. Moreover, the authors point out that the differences in
terms of point estimates, although relatively small in magnitude, may have
important effects on the moments of the model.
7. CONCLUSIONS AND OUTLOOK
There exists by now a large and growing body of empirical work on
the Bayesian estimation and evaluation of DSGE models. This paper has
surveyed the tools used in this literature and illustrated their performance
in the context of artiﬁcial data. While most of the existing empirical work
is based on linearized models, techniques to estimate DSGE models solved
with nonlinear methods have become implementable thanks to advances
in computing technology. Nevertheless, many challenges remain. Model
size and dimensionality of the parameter space pose a challenge for MCMC
methods. Lack of identiﬁcation of structural parameters is often difﬁcult to
detect since the mapping from the structural form of the DSGE model into
a state–space representation is highly nonlinear and creates a challenge
for scientiﬁc reporting as audiences are typically interested in disentangling
information provided by the data from information embodied in the
prior. Model misspeciﬁcation is and will remain a concern in empirical
work with DSGE models despite continuous efforts by macroeconomists
to develop more adequate models. Hence it is important to develop
methods that incorporate potential model misspeciﬁcation in the measures
of uncertainty constructed for forecasts and policy recommendations.
ACKNOWLEDGMENTS
Part of the research was conducted while Schorfheide was visiting
the Research Department of the Federal Reserve Bank of Philadelphia,
for whose hospitality he is grateful. The views expressed here are those
of the authors and do not necessarily reﬂect the views of the Federal
Reserve Bank of Philadelphia or the Federal Reserve System. We thank
Herman van Dijk and Gary Koop for inviting us to write this survey
paper for Econometric Reviews. We also thank our discussants as well as
Marco Del Negro, Jesús FernándezVillaverde, Thomas Lubik, Juan Rubio
Ramírez, Georg Strasser, seminar participants at Columbia University, and
Bayesian Analysis of DSGE Models 169
the participants of the 2006 EABCN Training School in Eltville for helpful
comments and suggestions. Schorfheide gratefully acknowledges ﬁnancial
support from the Alfred P. Sloan Foundation.
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Subsequently, many authors have developed econometric frameworks that formalize aspects of the calibration approach by taking model misspeciﬁcation explicitly into account. Examples are Smith (1993), Watson (1993), Canova (1994), DeJong et al. (1996), Diebold et al. (1998), Geweke (1999b), Schorfheide (2000), Dridi et al. (2007), and Bierens (2007). At the same time, macroeconomists have improved the structural models and relaxed many of the misspeciﬁed restrictions of the ﬁrst generation of DSGE models. As a consequence, more traditional econometric techniques have become applicable. The most recent vintage of DSGE models is not just attractive from a theoretical perspective but is also emerging as a useful tool for forecasting and quantitative policy analysis in macroeconomics. Moreover, owing to improved time series ﬁt these models are gaining credibility in policymaking institutions such as central banks. This paper reviews Bayesian estimation and evaluation techniques that have been developed in recent years for empirical work with DSGE models.1 We focus on methods that are built around a likelihood function derived from the DSGE model. The econometric analysis has to cope with several challenges, including potential model misspeciﬁcation and identiﬁcation problems. We will illustrate how a Bayesian framework can address these challenges. Most of the techniques described in this article have been developed and applied in other papers. Our contribution is to give a uniﬁed perspective, by applying these methods successively to artiﬁcial data generated from a DSGE model and a VAR. We provide some evidence on the performance of Markov Chain Monte Carlo (MCMC) methods that have been applied to the Bayesian estimation of DSGE models. Moreover, we present new results on the use of ﬁrstorder accurate versus secondorder accurate solutions in the estimation of DSGE models. The paper is structured as follows. Section 2 outlines two versions of a ﬁveequation New Keynesian DSGE model along the lines of Woodford (2003) that differ with respect to the monetary policy rule. This model serves as the foundation for the current generation of largescale models that are used for the analysis of monetary policy in academic and central bank circles. Section 3 discusses some preliminaries, in particular the challenges that have to be confronted by the econometric framework. We proceed by generating several data sets that are used subsequently for model estimation and evaluation. We simulate samples from the ﬁrstorder accurate solution of the DSGE model presented in Section 2, from a modiﬁed version of the DSGE model in order to introduce
There is also an extensive literature on classical estimation and evaluation of DSGE models, but a detailed survey of these methods is beyond the scope of this article. The interested reader is referred to Kim and Pagan (1995) and the book by Canova (2007), which discusses both classical and Bayesian methods for the analysis of DSGE models.
1
Bayesian Analysis of DSGE Models
115
misspeciﬁcation, and from the secondorder accurate solution of the benchmark DSGE model. Owing to the computational burden associated with the likelihood evaluation for nonlinear solutions of the DSGE model, most of the empirical literature has estimated linearized DSGE models. Section 4 describes a RandomWalk Metropolis (RWM) algorithm and an Importance Sampler (IS) algorithm that can be used to calculate the posterior moments of DSGE model parameters and transformations thereof. We compare the performance of the algorithms and provide an example in which they explore the posterior distribution only locally in the neighborhood of modes that are separated from each other by a deep valley in the surface of the posterior density. Model evaluation is an important part of the empirical work with DSGE models. We consider three techniques in Section 5: posterior predictive model checking, model comparisons based on posterior odds, and comparisons of DSGE models to VARs. We illustrate these techniques by ﬁtting correctly speciﬁed and misspeciﬁed DSGE models to artiﬁcial data. In Section 6 we construct posterior distributions for DSGE model parameters based on a secondorder accurate solution and compare them to posteriors obtained from a linearized DSGE model. Finally, Section 7 concludes and provides an outlook on future work. 2. A PROTOTYPICAL DSGE MODEL Our model economy consists of a ﬁnal goods producing ﬁrm, a continuum of intermediate goods producing ﬁrms, a representative household, and a monetary as well as a ﬁscal authority. This model has become a benchmark speciﬁcation for the analysis of monetary policy and is analyzed in detail, for instance, in Woodford (2003). To keep the model speciﬁcation simple, we abstract from wage rigidities and capital accumulation. More elaborate versions can be found in Smets and Wouters (2003) and Christiano et al. (2005). 2.1. The Agents and Their Decision Problems The perfectly competitive, representative, ﬁnal goods producing ﬁrm combines a continuum of intermediate goods indexed by j ∈ [0, 1] using the technology Yt =
0 1
1 1−
Yt (j )
1−
dj
(1)
Here 1/ > 1 represents the elasticity of demand for each intermediate good. The ﬁrm takes input prices Pt (j ) and output prices Pt as given.
which is treated as exogenous by the ﬁrm. real money balances.116 S. and leisure. Firms face nominal rigidities in terms of quadratic price adjustment costs ACt (j ) = Pt (j ) − Pt −1 (j ) 2 2 Yt (j ). Schorfheide Proﬁt maximization implies that the demand for intermediate goods is Yt (j ) = Pt (j ) Pt −1/ Yt (2) The relationship between intermediate goods prices and the price of the ﬁnal good is Pt = 0 1 Pt (j ) −1 −1 dj (3) Intermediate good j is produced by a monopolist who has access to the linear production technology Yt (j ) = At Nt (j ). We assume that the habit stock is given by the level of technology At . Labor is hired in a perfectly competitive factor market at the real wage Wt . This assumption ensures that the economy evolves along a balanced growth path even if the utility function is additively separable in consumption. An and F. (4) where At is an exogenous productivity process that is common to all ﬁrms and Nt (j ) is the labor input of ﬁrm j . (5) where governs the price stickiness in the economy and is the steadystate inﬂation rate associated with the ﬁnal good. The representative household derives utility from real money balances Mt /Pt and consumption Ct relative to a habit stock. (7) . Firm j chooses its labor input Nt (j ) and the price Pt (j ) to maximize the present value of future proﬁts ∞ t s=0 s Qt +st Pt +s (j ) Yt +s (j ) − Wt +s Nt +s (j ) − ACt +s (j ) Pt +s (6) Here Qt +st is the time t value of a unit of the consumption good in period t + s to the household. The household derives disutility from hours worked Ht and maximizes ∞ t s=0 s (Ct +s /At +s )1− − 1 + 1− M ln Mt +s Pt +s − H Ht +s .
and ∗ is the target inﬂation rate.t . which in equilibrium coincides with the steadystate inﬂation rate. where t ∈ [0. (9) where R . one in which the central bank reacts to inﬂation and deviations of output from potential output: Rt∗ = r ∗ t ∗ 1 Yt Yt∗ 2 (output gap rule speciﬁcation) (10) and a second speciﬁcation in which the central bank responds to deviations of output growth from its equilibrium steadystate : Rt∗ = r ∗ t ∗ 1 Yt Yt −1 2 (output growth rule speciﬁcation) (11) Here r is the steadystate real interest rate. Thus the household’s budget constraint is of the form Pt Ct + Bt + Mt − Mt −1 + Tt = Pt Wt Ht + Rt −1 Bt −1 + Pt Dt + Pt SCt . The household supplies perfectly elastic labor services to the ﬁrms taking the real wage Wt as given. it receives aggregate residual real proﬁts Dt from the ﬁrms and has to pay lumpsum taxes Tt . 1] follows an exogenous process. 1/ is the intertemporal elasticity of substitution. The government’s budget constraint is given by Pt Gt + Rt −1 Bt −1 = Tt + Bt + Mt − Mt −1 . The government levies a lumpsum tax (subsidy) to ﬁnance any shortfalls in government revenues (or to rebate any surplus). Monetary policy is described by an interest rate feedback rule of the form Rt = Rt ∗ 1− R R Rt −1 e R . The usual transversality condition on asset accumulation applies. The household has access to a domestic bond market where nominal government bonds Bt are traded that pay (gross) interest Rt . (12) . Yt∗ in (10) is the level of output that would prevail in the absence of nominal rigidities. t is the gross inﬂation rate deﬁned as t = Pt /Pt −1 . where Gt = t Yt . which rules out Ponzi schemes. We consider two speciﬁcations for Rt∗ . and M and H are scale factors that determine steadystate real money balances and hours worked. The ﬁscal authority consumes a fraction t of aggregate output Yt .Bayesian Analysis of DSGE Models 117 where is the discount factor. Furthermore.t is a monetary policy shock and Rt∗ is the (nominal) target rate. We will set H = 1. (8) where SCt is the net cash inﬂow from trading a full set of statecontingent securities.
interest rates.3. and R . 2.118 S.t (14) Finally. Aggregate productivity evolves according to ln At = ln + ln At −1 + ln zt . We assume that ln gt = (1 − g )ln g + g ln gt −1 + g . Deﬁne gt = 1/(1 − t ). Exogenous Processes The model economy is perturbed by three exogenous processes. consumption.2.t (13) Thus on average technology grows at the rate . the monetary policy shock R . respectively. The three innovations are independent of each other at all leads and lags and are normally distributed with means zero and standard deviations z . (19) . where ln zt = z ln zt −1 + z.t is assumed to be serially uncorrelated. Schorfheide 2. and zt captures exogenous ﬂuctuations of the technology growth rate. g . and inﬂation have to satisfy the following optimality conditions 1= 1= 1 t Ct +1 /At +1 Ct /At Ct At t − At Rt At +1 t +1 t (17) 1− 1 2 t +1 t 1− + ( Ct +1 /At +1 Ct /At − ) − + 2 t +1 − Yt +1 /At +1 ( Yt /At − ) (18) In the absence of nominal rigidities ( = 0) aggregate output is given by Yt∗ = (1 − )1/ At gt . Qt +st in (6) is Qt +st = (Ct +s /Ct )− (At /At +s )1− (16) It can be shown that output. The market clearing conditions are given by Yt = Ct + Gt + ACt and Ht = Nt (15) Since the households have access to a full set of statecontingent claims. An and F. Equilibrium Relationships We consider the symmetric equilibrium in which all intermediate goods producing ﬁrms make identical choices so that the j subscript can be omitted.
This rational expectations system has to be solved before the DSGE model can be estimated. Model Solutions Equations (21) to (26) form a nonlinear rational expectations system ˆ ˆ in the variables yt . zt ] Under the output growth rule speciﬁcation for Rt∗ the vector st also contains yt −1 .t y 2 (ˆt (24) (25) (26) gt = ˆ zt = ˆ ˆ g gt −1 ˆ z zt −1 For the output growth rule speciﬁcation.t . Rt . z. and zt that is driven by the vector of ˆ ˆ innovations t = [ R . R =r ∗ . y ˆ 2 ˆ ˆ R .Bayesian Analysis of DSGE Models 119 which is the target level of output that appears in the output gap rule speciﬁcation. ˆ t . Equation (24) is replaced by Rt = R Rt −1 + (1 − R) 1 ˆt + (1 − R) 2 yt + z t + ˆ ˆ R . ct . ˆ t .t are zero at all times. The model economy has a unique steadystate in terms of the detrended variables that is attained if the innovations R . g . and z.t . gt .4. and y = g (1 − )1/ (20) Let xt = ln (xt /x) denote the percentage deviation of a variable xt from its ˆ steadystate x.t (27) 2.t z.t y y e ˆ t +1 − 1 e − cˆt +1 + cˆt +ˆt +1 −ˆt + ˆ t +1 2 y e cˆt −ˆt = e −gˆt − g 2 e ˆt − 1 R) 2 Rt = R Rt −1 + (1 − R) 1 ˆt + (1 − + + g . Then the model can be expressed as 1= 1− 2 t z e − cˆt +1 + cˆt +Rt −ˆt +1 − ˆ t +1 (21) e ct ˆ − 1 = e ˆt − 1 − t 1− 1 2 e ˆt + 1 2 (22) (23) − gt ) + ˆ R .t .t .t . ˆ . Deﬁne2 st = [ˆt . it is convenient to express the model in terms of detrended variables ct = Ct /At and yt = Yt /At . Since the nonstationary technology process At induces a stochastic trend in output and consumption.t ] . c = (1 − )1/ . g . gt . The steadystate inﬂation equals the target rate ∗ and r = . Rt . ct .
the stable solution is unique (determinacy). In the context of likelihoodbased DSGE model estimation. Anderson (2000). j = 1. ) (28) From an econometric perspective. ˆ ˆ ˆ where = 1− 2 (32) Equations (29) to (31) combined with (24) to (26) and the trivial identity R .i si.l While in many applications ﬁrstorder approximations are sufﬁcient. the higherorder reﬁnement is an active area of research. For instance.t .t −1 i=1 sj . We will focus on the case of determinacy and restrict the parameter space accordingly. linear approximation methods are very popular because they lead to a state–space representation of the DSGE model that can be analyzed with the Kalman ﬁlter. An and F. Linearization and straightforward manipulation of Equations (21) to (23) yields yt = ˆ y t [ˆt +1 ] + gt − ˆ ˆt = ˆ t [gt +1 ] − 1 Rt − t [ t +1 ] − z t [ˆt +1 ] (29) (30) (31) t [ ˆ t +1 ] + (ˆt − gt ) y ˆ ct = yt − gt . Binder and Pesaran (1997). Christiano (2002). Kim (2000). A variety of numerical techniques are available to solve rational expectations systems. . Uhlig (1999). or there are multiple stable solutions (indeterminacy). Here the coefﬁcients j(s) and . for instance. t . The resulting law of motion for the j th element of st takes the form J n (s) j . . st can be viewed as a (partially latent) state vector in a nonlinear state space model and (28) is the state transition equation. and Sims (2002). Blanchard and Kahn (1980).t = + l =1 ( ) j .l l .i ( ) are functions of the structural parameters of the DSGE model. King and Watson (1998). Schorfheide The solution of the rational expectations system takes the form st = (st −1 .t form a linear rational expectations system in st for which several solution algorithms are available.120 S. j .t = R .J (33) Here J denotes the number of elements of the vector st and n is the number of shocks stacked in the vector t . Depending on the parameterization of the DSGE model there are three possibilities: no stable rational expectations solution exists.
A secondorder accurate solution to the DSGE model can be obtained from a secondorder expansion of the equilibrium conditions (21) to (26). and the second case arises if the percentage deviation of consumption from the steadystate is a linear function of the shock. Kim and Kim (2003) or Woodford (2003). is not affected by the coefﬁcients 1 and 2 of the monetary policy rule (24). for instance. then the expected utility is simply approximated by the steadystate utility U (0). a more accurate solution may be necessary. and Swanson et al.t −1 sl . A secondorder approximation of both U and C leads to 1 2 [U (ˆ )] = U (0) + U (2) (0)C (1) (c) c 2 2 1 + U (1) (0)C (2) (c) 2 2 + o( 2 ) (36) Using a secondorder expansion of the utility function together with a ﬁrstorder expansion of consumption ignores the second term in (36) and is only appropriate if either U (1) (0) or C (2) (c) is zero. Algorithms to construct such solutions have been developed by Judd (1998). Collard and Juillard (2001).il si.il si. which.l l . A simple example can illustrate this point.Bayesian Analysis of DSGE Models 121 if the goal of the analysis is to compare welfare across policies or market structures that do not have ﬁrstorder effects on the model’s steadystate or to study asset pricing implications of DSGE models. c 2 (34) where c is the percentage deviation of consumption from its steadystate ˆ and the superscript i denotes the ith derivative.t −1 i=1 J n (s ) j .il i.t l =1 n n ( ) j . see.i si. Suppose that consumption is a smooth function of a zero mean random shock which is scaled by . (2005). The resulting state transition equation can be expressed as J n (s) j . for instance.t i=1 l =1 J (ss) j .t −1 i=1 l =1 sj . The ﬁrst case arises if the marginal utility of consumption in the steadystate is zero.t −1 l . The secondorder approximation of c around the steadystate ( = 0) is ˆ c = C (1) (c) ˆ 1 + C (2) (c) 2 2 2 + op ( 2 ) (35) If ﬁrstorder approximations are used for both U and C .t l . Consider a oneperiod model in which utility is a smooth function of consumption and is approximated as 1 c c c U (ˆ ) = U (0) + U (1) (0)ˆ + U (2) (0)ˆ 2 + o(ˆ 2 ).t = (0) j + + + + + (37) . Jin and Judd (2002). (2005). SchmittGrohé and Uribe (2006). in the DSGE model described above.t i=1 l =1 J ( ) j . Kim et al.
Moreover. g. = 1 1 + r (A) /400 . Let =[ . there are several global approximation schemes. z. Measurement Equations The model is completed by deﬁning a set of measurement equations that relate the elements of st to a set of observables. For the subsequent analysis we use Sims’ (2002) procedure to compute a ﬁrstorder accurate solution of the DSGE model and SchmittGrohé and Uribe’s (2006) algorithm to obtain a secondorder accurate solution. R. deﬁned in (32). (2004) compare the accuracy of alternative solution methods. including projection methods such as the ﬁniteelements method and Chebyshev–polynomial method on the spectral domain. and Taylor and Uhlig (1990). z] For the quadratic approximation the composite parameter replaced by either ( . augmented with the steadystate ratio c/y. and Aruoba et al. annualized quartertoquarter inﬂation rates (INFL). we express the model in terms of . will be will be .122 S. 2. Judd (1998) covers various solution methods. R. 2. which is equal to 1/g . We assume that the time period t in the model corresponds to one quarter and that the following observations are available for estimation: quartertoquarter per capita GDP growth rates (YGR). =1+ 400 The structural parameters are collected in the vector . Den Haan and Marcet (1994). (Q ) . 1. The three series are measured in percentages.5. An and F. (A) . and r (A) are related to the steady states of the (A) 100 . Schorfheide As before. While perturbation methods approximate policy functions only locally. Since in the ﬁrstorder approximation the parameters and are not separately identiﬁable. the coefﬁcients are functions of the parameters of the DSGE model. and their relationship to the model variables is given by the set of equations YGRt = INFLt = INTt = The parameters (Q ) . ). . g. ) or alternatively by ( . r (A) . and annualized nominal interest rates (INT). model economy as =1+ (Q ) (A) (Q ) (A) (A) + 100(ˆt − yt −1 + zt ) y ˆ ˆ + 400 ˆ t +r (A) (38) (Q ) +4 + 400Rt .
Second. Hansen and Heckman (1996). the likelihood function by (  Y ). Leeper and Sims (1994).g. inﬂation. e. over generalized method of moments (GMM) estimation of equilibrium relationships.g. Much of the methodological debate surrounding the various estimation (and model evaluation) techniques is summarized in papers by Kydland and Prescott (1996). We focus on Bayesian estimation of DSGE models. Potential Model Misspeciﬁcation If one predicts a vector of time series yt . e. Kydland and Prescott (1982). the estimation is based on the likelihood function generated by the DSGE model rather than.Bayesian Analysis of DSGE Models 123 3. prior distributions can be used to incorporate additional information into the parameter estimation. 3. or the monetary policy rule (24). minimum distance estimation based on the discrepancy among VAR and DSGE model impulse response functions. In the context of the model developed in Section 2 yt is composed of YGRt . We will subsequently elaborate these challenges and discuss how a Bayesian approach can be used to cope with them. INTt . for instance composed of output growth. Throughout the paper we will use the following notation: the n × 1 vector yt stacks the time t observations that are used to estimate the DSGE model.g. ranging from calibration. First. by a function of past yt ’s. for instance. (2005). and Sims (1996). McGrattan (1994). then the resulting forecast error covariance matrix is nonsingular. INFLt . unlike GMM estimation based on equilibrium relationships such as the consumption Euler equation (21). Christiano and Eichenbaum (1992). The sample ranges from t = 1 to T and the sample observations are collected in the matrix Y with rows yt . Any estimation and evaluation method is confronted with the following challenges: potential model misspeciﬁcation and possible lack of identiﬁcation of parameters of interest.. Rotemberg and Woodford (1997) and Christiano et al. and Kim (2000). Third.. the price setting equation of the intermediate goods producing ﬁrms (22).1. We denote the prior density by p( ). e. PRELIMINARIES Numerous formal and informal econometric procedures have been proposed to parameterize and evaluate DSGE models. which has three main characteristics. the Bayesian analysis is systembased and ﬁts the solved DSGE model to a vector of aggregate time series. and nominal interest rates. to fullinformation likelihoodbased estimation as in Altug (1989). Hence any DSGE model that generates a rankdeﬁcient covariance matrix for yt is clearly at odds with the data and suffers from an obvious form . the discrepancy between DSGE model responses and VAR impulse responses.. and the posterior density by p(  Y ).
Sargent (1989). Likelihoodbased estimators. simultaneously. say.g. or additional structural shocks as in Leeper and Sims (1994) and more recently Smets and Wouters (2003). Time series estimates of aggregate labor supply elasticities or price adjustment costs should be broadly consistent with microlevel evidence. due to the stylized nature and the resulting misspeciﬁcation . Schorfheide of misspeciﬁcation. For example. An and F. then it seems reasonable to assume that there need not exist a single parameter vector 0 that delivers.124 S. One reason that pure maximum likelihood estimation of DSGE models has not turned into the estimation method of choice is the “dilemma of absurd parameter estimates. asymptotically minimize the Kullback–Leibler distance (see White. While the primary research objectives in the DSGE model literature is to overcome discrepancies between models and reality. e. technology growth shock) equals the number of observables (output growth. whereas the other branch has modiﬁed the model speciﬁcation to remove the singularity by adding socalled measurement errors. Once one acknowledges that the DSGE model provides merely an approximation to the law of motion of the time series yt . (2006) document that even an elaborate DSGE model with capital accumulation and various nominal and real frictions has difﬁculties attaining the ﬁt achieved with VARs that have been estimated with welldesigned shrinkage methods. the most precise impulse responses to a technology or monetary policy shock. inﬂation. Altug (1989). estimates of the discount factor should be consistent with our knowledge about the average magnitude of real interest rates. interest rates) to which the model is ﬁtted. even if observations on interest rates are not included in the estimation sample Y . Hence one branch of the literature has emphasized procedures that can be applied despite the singularity. This singularity is an obstacle to likelihood estimation. the “true” intertemporal substitution elasticity or price adjustment costs and.. for instance. In this paper we pursue the latter approach by considering a model in which the number of structural shocks (monetary policy shock. Invalid restrictions manifest themselves in poor outofsample ﬁt relative to more densely parameterized reference models such as VARs. However. 1982). Each estimation method is associated with a particular measure of discrepancy between the ‘true’ law of motion and the class of approximating models. A second source of misspeciﬁcation that is more difﬁcult to correct is potentially invalid crosscoefﬁcient restrictions on the time series representation of yt generated by the DSGE model. it is important to have empirical strategies available that are able to cope with potential model misspeciﬁcation. Ireland (2004).” Estimates of structural parameters generated with maximum likelihood procedures based on a set of observations Y are often at odds with additional information that the research may have. Del Negro et al. government spending shock.
recent experience with the estimation of New Keynesian DSGE models has cast some doubt on this notion and triggered a more careful assessment. Identiﬁcation Identiﬁcation problems can arise owing to a lack of informative observations or. then the marginal data density of the DSGE model. whereas the latter paper compares the informativeness of different estimators with respect to key structural parameters in a variety of DSGE models.Bayesian Analysis of DSGE Models 125 of most DSGE models. the shift from prior to posterior distribution can be an indicator of the tension between different sources of information. from a probability model that implies that different values of structural parameters lead to the same joint distribution for the observables Y . more fundamentally. (39) will be low compared to. The former paper provides an algorithm to construct families of observationally equivalent linear rational expectations models. Section 5 will discuss several methods that have been proposed to assess the ﬁt of DSGE models: posterior odds comparisons of competing model speciﬁcations. Lack of identiﬁcation is documented in papers by Beyer and Farmer (2004) and Canova and Sala (2005). a VAR. and comparisons to reference models that relax some of the crosscoefﬁcient restrictions generated by the DSGE models.2. In a Bayesian framework. the likelihood function often peaks in regions of the parameter space that appear to be inconsistent with extraneous information. the likelihood function is reweighted by a prior density. 3. Since priors are always subject to revision. If the likelihood function peaks at a value that is at odds with the information that has been used to construct the prior distribution. At ﬁrst glance the identiﬁcation of DSGE model parameters does not appear to be problematic. posterior predictive checks. The delicate identiﬁcation problems that arise in rational expectations models can be illustrated in a simple example adopted from Lubik and Schorfheide (2006). and in a posterior odds comparison the DSGE model will automatically be penalized for not being able to reconcile the two sources of information with a single set of parameters. say. The prior can bring to bear information that is not contained in the estimation sample Y . However. The parameter vector is typically low dimensional compared to VARs and the model imposes tight restrictions on the time series representation of Y . in which yt is . Consider the following two models. deﬁned as p(Y ) = (  Y )p( )d .
Here = [ .  Y ) = ( ). t ∼ iid 0.  Y ) = p(  Y )p(  ) 3 (43)  − 2 To 2  + ensure determinacy − 4  > 2 in 2 . the parameters and are not separately identiﬁable.126 S. Moreover. t ∼ iid(0. An and F. models 1 and 2 are observationally equivalent. While Bayesian inference is based on the likelihood function. Straightforward manipulations of the Bayes theorem yield p( . In model 1 . t ∼ iid 0. and in model 2 . The calculation of a valid conﬁdence set is challenging since it is difﬁcult to trace out the parameter subspace along which the likelihood function is constant. Schorfheide the observed endogenous variable and ut is an unobserved shock process. (1 − / )2 (40) In model 2 the shocks are serially uncorrelated. 2 : = 1 ( − 2 2 −4 ) In model 1 the parameter is not identiﬁable. even a weakly informative prior can introduce curvature into the posterior density surface that facilitates numerical maximization and the use of MCMC methods. the ut ’s are serially correlated: 1 : yt = 1 t [yt +1 ] + ut . The likelihood functions of 1 and 2 have ridges that can cause serious problems for numerical optimization procedures. 2 ut = 2 t. + −4 (41) 2 For both speciﬁcations. ] and the likelihood function can be written as ( . ut = ut −1 + t . Consider model 1 . we impose >1 in 1 and −4 < 2 and . the law of motion of yt is yt = yt −1 + t. 1) (42) Under restrictions on the parameter spaces that guarantee uniqueness of a stable rational expectations solution3 we obtain the following relationships between and the structural parameters: 1 : = . but we introduce a backwardlooking term yt −1 on the righthand side to generate persistence: 2 : yt = 1 t [yt +1 ] + yt −1 + ut .
However. in principle. for instance. inﬂation. (A) . 3. in Bils and Klenow (2004). In the latter case priors are essentially used to reduce the dimensionality of the econometric model and hence the sampling variability of the parameter estimates. in practice most priors are chosen based on some observations. Lubik and Schorfheide (2006) estimate a twocountry version of the model described in Section 2. Priors As indicated in our previous discussion. it is often helpful to simulate the prior predictive distribution for various sample moments and check that 4 The role of priors in DSGE model estimation is markedly different from the role of priors in VAR estimation. as the audience typically would like to know what features of the posterior are generated by the prior rather than the likelihood. the steadystate parameters (Q ) . priors can be gleaned from personal introspection to reﬂect strongly held beliefs about the validity of economic theories.Bayesian Analysis of DSGE Models 127 Thus the prior distribution is not updated in directions of the parameter space in which the likelihood function is ﬂat. For instance. prior distributions will play an important role in the estimation of DSGE models. . as well as the standard deviation of the monetary policy shock. lack of identiﬁcation provides a challenge for scientiﬁc reporting. in particular the distribution of shock standard deviations. since the mapping from the vector of structural parameters into the state–space representation that determines the joint probability distribution of Y is highly nonlinear and typically can only be evaluated numerically.3.4 While. see Poirier (1998) for a discussion. To ﬁnetune the prior distribution. and r (A) . A direct comparison of priors and posteriors can often provide valuable insights about the extent to which data provide information about the parameters of interest. This is of course well known in Bayesian econometrics. and nominal interest rates. They might downweigh regions of the parameter space that are at odds with observations not contained in the estimation sample Y . are quantiﬁed based on regressions run on pre(estimation)sample observations of output growth. It is difﬁcult to detect directly identiﬁcation problems in large DSGE models. Priors for the autocorrelations and standard deviations of the exogenous processes. They might also add curvature to a likelihood function that is (nearly) ﬂat in some dimensions of the parameter space and therefore strongly inﬂuence the shape of the posterior distribution. The prior for the parameter that governs price stickiness is chosen based on microevidence on price setting behavior provided. The posterior distribution is well deﬁned as long as the joint prior distribution of the parameters is proper. The priors for the coefﬁcients in the monetary policy rule are loosely centered around values typically associated with the Taylor rule.
(24) is replaced by Eq. (21)–(26). which induce dependent priors for the original parameters. An and F. Hence. The parameters (conditional on ) and 1/g only affect the secondorder approximation of the DSGE model. (1 + h)ˆt = y 1 (L) 1 (Q ) 2 (L) 5 (L) + h yt −1 + gt − ˆ ˆ ˆ t [gt +1 ] − 1 Rt − t [ t +1 ] − [ˆt +1 ] with h = 95. autocorrelations. Schorfheide the prior does not place little or no mass in a neighborhood of important features of the data. 2 1 (L). 3. solved by ﬁrstorder approximation. except that central bank does not respond to the output gap: 1 (L). consists of Eqs. Same as Same as Same as 1 (L). Eq. or relative volatilities. TABLE 1 Model speciﬁcations and data sets 1 (L) 1 (Q ) 2 (L) Benchmark Model with output gap rule. solved by ﬁrstorder approximation. solved by secondorder approximation. (21)–(26). consists of Eqs. z 80 observations generated with 80 observations generated with 80 observations generated with 80 observations generated with 1 (L) 1 (Q ) 2 (L) 5 (L) . consists of Eqs. it is assumed that all parameters are a priori independent. A formalization of such a prior predictive check can be found in Geweke (2005). rational expectations models can have multiple equilibria. that we will use in the subsequent analysis. Such an occurrence would suggest that the model is incapable of explaining salient data properties. DSGE Model with output growth rule. Table 2 lists the marginal prior distributions for the structural parameters of the DSGE model. In applications in which the independence assumption is unreasonable one could derive parameter transformations. Benchmark Model with output gap rule. (29)is replaced by t [yt +1 ] = 0. 3 (L) 4 (L) 5 (L) except that prices are nearly ﬂexible: = 5. As mentioned before. the prior distribution is truncated at the boundary of the determinacy region. such as steady rate ratios. The Road Ahead Throughout this paper we are estimating and evaluating versions of the DSGE model presented in Section 2 based on simulated data.128 S. and specify independent priors on the transformed parameters. except in ﬁrstorder approximation Eq.4. (27). Prior to the truncation the distribution speciﬁed in Table 2 places about 2% of its mass on parameter values that imply indeterminacy. For convenience. (21)–(26). however. Table 1 provides a characterization of the model speciﬁcations and data sets. While this may be of independent interest we do not pursue this direction in this paper. These priors are adopted from Lubik and Schorfheide (2006).
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Model 1 is the benchmark speciﬁcation of the DSGE model in which monetary policy follows an interestrate rule that reacts to the output gap. 1 (L) is approximated by a linear rational expectations system, whereas 1 (Q ) is solved with a secondorder perturbation method. In 2 (L) we replace the output gap in the interestrate feedback rule by output growth. 3 and 4 are identical to 1 (L), except that in one case we impose that the prices are nearly ﬂexible ( = 5) and in the other case the central bank does not respond to output ( 2 = 0). In 5 (L) we replace the loglinearized consumption Euler equation by an equation that includes lagged output on the righthand side. Loosely speaking, this speciﬁcation can be motivated with a model in which agents derive utility from the difference between individual consumption and the overall level of consumption in the previous period. Conditional on parameter vectors reported in Tables 2 and 3 we generate four data sets with 80 observations each. We use the labels 1 (L), 1 (Q ), 2 (L), and 5 (L) to denote data sets generated from 1 (L), (Q ), 2 (L), and 5 (L), respectively. By and large, the values for the 1 DSGE model parameters resemble empirical estimates obtained from post1982 U.S. data. The sample size is fairly realistic for the estimation of monetary DSGE model. Many industrialized countries experienced a high inﬂation episode in the 1970s that ended with a disinﬂation in the 1980s. Subsequently, the level and the variability of inﬂation and interest rates have been fairly stable, so that it is not uncommon to estimate constant coefﬁcient DSGE models based on data sets that begin in the early 1980s.
TABLE 2 Prior distribution and DGPs—linear analysis (Sections 4 and 5) Prior Name Domain
+ + 1 2 R G Z + +
Density Gamma Gamma Gamma Gamma Beta Beta Beta Gamma Gamma Normal InvGamma InvGamma InvGamma
Para (1) 2 00 20 1 50 50 50 80 66 50 7 00 40 40 1 00 50
Para (2) 50 10 25 25 20 10 15 50 2 00 20 4 00 4 00 4 00
1 (L),
DGP 2 (L), 2 00 15 1 50 1 00 60 95 65 40 4 00 50 20 80 45
5 (L)
[0, 1) [0, 1) [0, 1)
+ + + + +
r (A)
(A) (Q )
100 100 100
R G Z
Notes: Paras (1) and (2) list the means and the standard deviations for Beta, Gamma, and Normal distributions; the upper and lower bound of the support for the Uniform distribution; s and for 2 2 the Inverse Gamma distribution, where p G (  , s) ∝ − −1 e − s /2 . The effective prior is truncated at the boundary of the determinacy region.
130
S. An and F. Schorfheide
TABLE 3 Prior distribution and DGP—Nonlinear analysis (Section 6) Prior Name Domain
+ + 1 2 R G Z + +
Density Gamma Gamma Gamma Gamma Beta Beta Beta Gamma Gamma Normal InvGamma InvGamma InvGamma Beta Beta
Para (1) 2 00 30 1 50 50 50 80 66 80 4 00 40 30 40 40 10 85
Para (2) 50 20 25 25 20 10 15 50 2 00 20 4 00 4 00 4 00 05 10
DGP 1 (Q ) 2 00 33 1 50 125 75 95 90 1 00 3 20 55 20 60 30 10 85
[0, 1) [0, 1) [0, 1)
+ + + + +
r (A)
(A) (Q )
100 100 100 1/g
R G Z
[0, 1) [0, 1)
Notes: See Table 2. Parameters solution of the DSGE model.
and 1/g only affect the secondorder accurate
Section 4 illustrates the estimation of linearized DSGE models under correct speciﬁcation, that is, we construct posteriors for 1 (L) and 2 (L) based on the data sets 1 (L) and 2 (L). Section 5 considers model evaluation techniques. We begin with posterior predictive checks in Section 5.1, which are implemented based on 1 (L) for data sets 1 (L) (correct speciﬁcation of DSGE model) and 5 (L) (misspeciﬁcation of the consumption Euler equation). In Section 5.2 we proceed with the calculation of posterior model probabilities for speciﬁcations 1 (L), 4 (L) conditional on the data set 1 (L). Subsequently in 3 (L), and Section 5.3 we compare 1 (L) to a vector autoregressive speciﬁcation using 1 (L) (correct speciﬁcation) and 5 (L) (misspeciﬁcation). Finally, in Section 6 we study the estimation of DSGE models solved with a secondorder perturbation method. We compare posteriors for 1 (Q ) and 1 (L) conditional on 1 (Q ). 4. ESTIMATION OF LINEARIZED DSGE MODELS We will begin by describing two algorithms that can be used to generate draws from the posterior distribution of and subsequently illustrate their performance in the context of models 1 (L)/ 1 (L) and 2 (L)/ 2 (L). 4.1. Posterior Computations We consider an RWM algorithm and an IS algorithm to generate draws from the posterior distribution of . Both algorithms require the evaluation
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of (  Y )p( ). The computation of the nonnormalized posterior density proceeds in two steps. First, the linear rational expectations system is solved to obtain the state transition equation (33). If the parameter value implies indeterminacy (or nonexistence of a stable rational expectations solution), then (  Y )p( ) is set to zero. If a unique stable solution exists, then the Kalman ﬁlter5 is used to evaluate the likelihood function associated with the linear state–space system (33) and (38). Since the prior is generated from wellknown densities, the computation of p( ) is straightforward. The RWM algorithm belongs to the more general class of Metropolis– Hastings algorithms. This class is composed of universal algorithms that generate Markov chains with stationary distributions that correspond to the posterior distributions of interest. A ﬁrst version of such an algorithm had been constructed by Metropolis et al. (1953) to solve a minimization problem and was later generalized by Hastings (1970). Chib and Greenberg (1995) provide an excellent introduction to Metropolis– Hastings algorithms. The RWM algorithm was ﬁrst used to generate draws from the posterior distribution of DSGE model parameters by Schorfheide (2000) and Otrok (2001). We will use the following implementation based on Schorfheide (2000):6 RandomWalk Metropolis (RWM) Algorithm Use a numerical optimization routine to maximize ln (  Y ) + ln p( ). Denote the posterior mode by ˜ . Let be the inverse of the Hessian computed at the posterior mode ˜ . 2 Draw (0) from ( ˜ , c0 ) or directly specify a starting value. For s = 1, , nsim , draw from the proposal distribution ( (s−1) , c 2 ). The jump from (s−1) is accepted ( (s) = ) with probability min 1, r ( (s−1) ,  Y ) and rejected ( (s) = (s−1) ) otherwise. Here r(
(s−1)
1. 2. 3. 4.
,
Y) =
(
(s−1)
(  Y )p( )  Y )p( (s−1) )
5. Approximate the posterior expected value of a function h( ) by nsim 1 (s) ). s=1 h( nsim
Since according to our model st is stationary, the Kalman ﬁlter can be initialized with the unconditional distribution of st . To make the estimation in Section 4 comparable to the DSGEVAR analysis presented in Section 5.3 we adjust the likelihood function to condition on the ﬁrst four observations in the sample: (  Y )/ (  y1 , , y4 ). These four observations are later used to initialize the lags of a VAR. 6 This version of the algorithm is available in the userfriendly DYNARE (2005) package, which automates the Bayesian estimation of linearized DSGE models and provides routines to solve DSGE models with higherorder perturbation methods.
5
An and F. Prior to the numerical maximization we transform all parameters so that their domain is unconstrained. and Kim (1998).g. There typically exists a range for d over which the derivatives are stable. The particular version of the IS algorithm used subsequently is of the following form. While Steps 1 and 2 are not necessary for the implementation of the RWM algorithm.132 S. . The elements of the Hessian matrix in Step 2 are computed numerically for various values of the increment d . The algorithm uses a fairly simple line search and randomly perturbs the search direction if it reaches a cliff caused by nonexistence or nonuniqueness of a stable rational expectations solution for the DSGE model. the posterior distribution of will be asymptotically normal. Walker (1969). 2005) reviews regularity conditions that guarantee the convergence of the Markov chain generated by Metropolis–Hastings algorithms to the posterior distribution of interest nsim 1 and the convergence of nsim s=1 h( (s) ) to the posterior expectations [h( )  Y ]. e. they are often helpful. The idea of the algorithm is based on the identity [h( )  Y ] = h( )p(  Y )d = h( )p(  Y ) q( )d q( ) Draws from the posterior density p(  Y ) are replaced by draws from the density q( ) and reweighted by the importance ratio p(  Y )/q( ) to obtain a numerical approximation of the posterior moment of interest. Crowder (1988). The algorithm constructs a Gaussian approximation around the posterior mode and uses a scaled version of the asymptotic covariance matrix as the covariance matrix for the proposal distribution. (2000) used an IS algorithm to calculate posterior moments of the parameters of a linearized stochastic growth model. The maximization of the posterior density kernel is carried out with a version of the BFGS quasiNewton algorithm.. Schorfheide Under fairly general regularity conditions. This allows for an efﬁcient exploration of the posterior distribution at least in the neighborhood of the mode. Geweke (1999a. written by Chris Sims for the maximum likelihood estimation of a DSGE model conducted in Leeper and Sims (1994). As d approaches zero the numerical derivatives will eventually deteriorate owing to inaccuracies in the evaluation of the objective function. DeJong et al. Hammersley and Handscomb (1964) were among the ﬁrst to propose this method and Geweke (1989) provides important convergence results. The RWM algorithm generates a sequence of dependent draws from the posterior distribution of that can be averaged to approximate posterior moments. This parameter transformation is only used in Step 1 of the RWM algorithm.
the posteriors of steadystate parameters. 4. s=1 w( The accuracy of the IS approximation depends on the similarity between posterior kernel and importance density. we generate 200 independent draws from the truncated prior distribution. An introduction to this . then the importance weights ws are constant and one averages independent draws to approximate the posterior expectations of interest. Let q( ) be the density of a multivariate t distribution with mean ˜ . There is. Denote the posterior mode by ˜ . c = 0 3) to generate 1 million draws from the posterior distribution. and the shock standard deviations are sharply peaked relative to the prior distributions. information about the degree of pricestickiness. 5. nsim generate draws (s) from q( ). The lack of information about some of the key structural parameters resembles the empirical ﬁndings based on actual observations. Moreover. the autocorrelation coefﬁcients. scale matrix c 2 . We construct a Gaussian approximation of the posterior near the mode. ˜ Approximate the posterior expected value of a function h( ) by nsim (s) )h( (s) ).000th draw from the posterior distribution in twodimensional scatter plots. A visual comparison of priors and posteriors suggests that the 80 observations sample contains little information on the riskaversion parameter and the policy rule coefﬁcients 1 and 2 . nsim ˜ ˜ Compute ws = ( (s)  Y )p( (s) )/q( (s) ) and ws = ws / s=1 ws . 3. If the importance density concentrates its mass in a region of the parameter space in which the posterior density is very low. Let be the inverse of the Hessian computed at the posterior mode ˜ . and replace the normal distribution with a fattailed t distribution to implement the algorithm. Simulation Results for 1 (L) 1 (L)/ 1 (L) We begin by estimating the loglinearized output gap rule speciﬁcation based on data set 1 (L). 4. For s = 1. 2. 6. captured by the slope coefﬁcient of the Phillipscurve relationship (30). however. .2. The rejection rate is about 45%. Moreover. There exists an extensive literature on convergence diagnostics for MCMC methods such as the RWM algorithm. and degrees of freedom. We also indicate the location of the posterior mode in the 12 panels of the ﬁgure. If the two are equal. scale the asymptotic covariance matrix. We use the RWM algorithm (c0 = 1. then most of the ws ’s will be much smaller than 1/nsim and the approximation method is inefﬁcient. Figure 1 depicts the draws from the prior as well as every 5.Bayesian Analysis of DSGE Models 133 1. Importance Sampling (IS) Algorithm Use a numerical optimization routine to maximize ln (  Y ) + ln p( ).
we set c = 0 3. ( 4. all parameters are initialized at their posterior mode values. we will compare draws and recursively computed means from multiple chains. We run four independent Markov chains. 2 0). 2 0). Schorfheide FIGURE 1 Prior and posterior – Model 1 (L). 1) and (1. While many convergence diagnostics are based on formal statistical tests.000th draw of ( . convergence of empirical averages to posterior moments. 1). Panels (1. Except for and 2 . More speciﬁcally. literature can be found. and plot every 5. (3 0. Data 1 (L). The initial values for ( . 2 ) are (3 0. generate 1 million draws for each chain. The panels depict 200 draws from prior and posterior distributions. These authors distinguish between convergence of the Markov chain to its stationary distribution. As before. in Robert and Casella (1999). and convergence to iid sampling.134 S. 2 ) in Figure 2. Visual inspection of . and ( 6. An and F. Intersections of solid lines signify posterior mode values. we will consider informal graphical methods in this paper. respectively. 2) of the ﬁgure depict posterior contours at the posterior mode. 1). for instance.
the plots suggests that all four chains. Panels (2.2): 200 draws from four Markov chains generated by the Metropolis Algorithm. Since neither the IS nor the RWM approximation of the posterior means are exact. Intersections of solid lines signify posterior mode values. For the importance sampler we follow Geweke (1999b). As for the draws from the RWM algorithm. converge to the same (stationary) distribution and concentrate in the highposterior density region. We generate another set of 1 million draws using the IS algorithm with = 3 and c = 1 5.1) and (1. and for the Metropolis chain we use Newey–West standard error estimates.Bayesian Analysis of DSGE Models 135 FIGURE 2 Draws from multiple chains – Model 1 (L).1) to (3. Despite different initializations. despite the use of different starting values. Data 1 (L). we construct standard error estimates. Panels (1. Figure 3 plots recursive means for the four chains. the means converge in the long run.2): contours of posterior density at “low” and “high” mode as function of and 2 . truncated at 140 lags.7 In Figure 4 we plot (recursive) conﬁdence intervals for the RWM and the IS approximation of the posterior means. we compute recursive means. . For most parameters the two 7 It is not guaranteed that the Newey–West standard errors are formally valid.
The value of . 4. the magnitude of the discrepancy is generally small relative to. One of the modes. Schorfheide FIGURE 3 Recursive means from multiple chains – Model 1 (L). and g . A Potential Pitfall: Simulation Results for 2 (L)/ 2 (L) We proceed by estimating the output growth rule version 2 (L) of the DSGE model based on 80 observations generated from this model (Data Set 2 (L)). say. Each line corresponds to recursive means (as a function of the number of draws) calculated from one of the four Markov chains generated by the Metropolis Algorithm. . for instance. Data 1 (L). the 2 (L) posterior has (at least) two modes. ˜ (h) . Unlike the posterior for the output gap version. r (A) . However. An and F. is located at = 2 06 and 2 = 97. g . Exceptions are. which we label the “high” mode.3.136 S. the difference between the posterior mode and the estimated posterior means. conﬁdence intervals overlap.
The intersection of the solid lines in panels (1. Similarly. ˜ (l ) .1) is constructed by setting = ˜ (l ) and then graphing posterior contours for ∈ [0. 2 5]. and (3.1). recursively computed 95% bands for posterior means based on the metropolis algorithm (dotted) and the importance sampler (dashed). 3] and 2 ∈ [0. is located at = 1 44 and 2 = 81 and attains the value −183 23.1). The ﬁrst two panels of Figure 5 depict the contours of the nonnormalized posterior density as a function of and 2 at the low and the high mode. whereas the solid lines in the remaining panels indicate the location of the high mode. . Panels depict posterior modes (solid). ﬁxing the other parameters at their respective ˜ (h) values. Importance Sampling – Model 1 (L). The second (“low”) mode.1) signify the low mode. Panel (1.2) is obtained by exploring the shape of the posterior as a function of and 2 . Panel (1.Bayesian Analysis of DSGE Models 137 FIGURE 4 RWM algorithm vs. respectively. Data 1 (L). keeping all other parameters ﬁxed at their respective ˜ (l ) values. (2. ln [ (  Y )p( )] is equal to −175 48.
2 0). Unlike in Panels (1. It turns out that Chains 1 and 3 explore the posterior distribution locally in the neighborhood of the low mode. (3 0. whereas Chains 2 and 4 move through the posterior surface near the high mode.8 We plot every 5.1) to (3.1) to (3. 1).000th draw of and 2 from the four Markov chains in Panels (2.2). and ( 6.2 we generate 1 million draws each for model 2 from four Markov chains that were initialized at the following values for ( . Panels (2.2). 1). The two modes are separated by a deep valley which is caused by complex eigenvalues of the state transition matrix. The remaining parameters were initialized at the low (high) mode for Chains 1 and 3 (2 and 4). 2 0). An and F. Intersections of solid lines signify “low” (left panels) and “high” (right panels) posterior mode values. ( 4.1) and (1. Panels (1.2): contours of posterior density at “low” and “high” mode as function of and 2 . As in Section 4. Data 2 (L). Schorfheide FIGURE 5 Draws from multiple chains – Model 2 (L). the remaining parameters are not ﬁxed at their ˜ (l ) and ˜ (h) values. Given the conﬁguration of the RWM algorithm the likelihood The covariance matrices of the proposal distributions are obtained from the Hessians associated with the respective modes. 2 ): (3 0.2): 200 draws from four Markov chains generated by the metropolis algorithm.1) and (1. 8 .138 S.
Nevertheless. Two remarks are in order. The recursive means associated with the four chains are plotted in Figure 6. We explored various modiﬁcations of the RWM algorithm by changing the scaling factor c and by setting the offdiagonal elements of to zero. extremum estimators that are computed with numerical optimization methods suffer from the same problem as FIGURE 6 Recursive means from multiple chains – Model 2 (L).000. it only explores the posterior in the neighborhood of one of the modes. corresponding to the two posterior modes. First. While each chain appears to be stable.000 draws were insufﬁcient for the chains initialized at the low mode to cross over to the neighborhood of the high mode. Each line corresponds to recursive means (as a function of the number of draws) calculated from one of the four Markov chains generated by the metropolis algorithm. Data ( L). 1.Bayesian Analysis of DSGE Models 139 of crossing the valley that separates the two modes is so small that it did not occur. They exhibit two limit points. .
in Bayesian computation it is helpful to start MCMC methods from different regions of the parameter space. government spending shocks. The posterior draws are obtained by converting every 5.1) and (2. The corners Z .140 S. and R of the triangles correspond to decompositions in which the shocks z . The data provide additional information about the variance decomposition. Second. Fluctuations of output growth. and monetary policy shocks. Panels (1. it is good practice to start the optimization from different points in the parameter space to increase the likelihood that the global optimum is found. One might ﬁnd a local rather than the global extremum of the objective function. Schorfheide the Bayes estimators in this example. Parameter Transformations for 1 (L)/ 1 (L) Macroeconomists are often interested in posterior distributions of parameter transformations h( ) to address questions such as what fraction of the variation in output growth is caused by monetary policy shocks. A priori about 10% of the variation in output growth is due to monetary policy shocks. and what happens to output and inﬂation in response to a monetary policy shock. which can be depicted as a triangle in 2 . g . We will focus on variance decompositions in the remainder of this subsection. inﬂation. respectively. and nominal interest rate in the DSGE model are due to three shocks: technology growth shocks. in many applications as well as in this example there exists a global mode that dominates the local modes.000th draw generated with the RWM algorithm. All subsequent computations are based on the output gap rule speciﬁcation of the DSGE model. Hence. 4. Hence an exploration of the posterior in the neighborhood of the global mode might still provide a good approximation to the overall posterior distribution. While the prior mean of the fraction of inﬂation variability explained by the monetary policy shock is about 40%. G . An and F. For instance.4. a 90% probability interval ranges from 0 to 95%. Hence all prior and posterior draws concentrate on the R − Z edge of the simplex. Hence variance decompositions of the endogenous variables lie in a threedimensional simplex.1) indicate that the prior distribution of the variance decomposition is informative in the sense that it is not uniform over the simplex. or vary the distribution q( ) in the importance sampler. The posterior distribution . Answers can be obtained from the moving average representation associated with the state space model composed of (33) and (38). the output gap policy rule speciﬁcation 1 implies that the government spending shock does not affect inﬂation and nominal interest rates. and R explain 100% of the variation. A 90% probability interval ranges from 0 to 20%. Similarly. In Figure 7 we plot 200 draws from the prior distribution (left panels) and 200 draws from the posterior (right panels) of the variance decompositions of output growth and inﬂation.
The following incomplete list of references aims to give an overview of this work. DeJong et al.5. Leeper and Sims (1994) and Kim (2000) estimated DSGE models that are usable for monetary policy analysis. Canova (1994).Bayesian Analysis of DSGE Models 141 FIGURE 7 Prior and posterior variance decompositions – Model 1 (L).t . (1996).t . Data 1 (L). g . respectively. The posterior probability interval for the fraction of inﬂation variability explained by the monetary policy shock ranges from 15 to 37%. 4. is much more concentrated than the prior.G.t . and R . and Geweke (1999a) proposed Bayesian approaches to calibration that do not exploit the likelihood function of the DSGE model and provide empirical applications that assess business cycle and asset pricing implications of simple stochastic growth . and McGrattan (1994) studies the macroeconomic effects of taxation in an estimated business cycle model. Altug (1989) estimates Kydland and Prescott’s (1982) timetobuild model.5%. Empirical Applications There is a rapidly growing empirical literature on the Bayesian estimation of DSGE models that applies the techniques described in this paper. Preceding the Bayesian literature are papers that use maximum likelihood techniques to estimate DSGE models. The panels depict 200 draws from prior and posterior distributions arranged on a 3dimensional simplex. The probability interval for the contribution of monetary policy shocks to output growth ﬂuctuations shrinks to the range from 1 to 4.R) correspond to 100% of the variation being due to the shocks z. The three corners (Z.
(2006) to study monetary policy. Rabanal and Tuesta (2006). DeJong et al. and New Zealand respond to exchange rates. Schorfheide (2005) allows for regimeswitching of the target inﬂation level in the monetary policy rule. Largescale models that include capital accumulation and additional real and nominal frictions along the lines of Christiano et al. Otrok (2001) ﬁts a real business cycle with habit formation and timetobuild to the data to assess the welfare costs of business cycles. . whereas Chang et al. Chang and Schorfheide (2003) study the importance of labor supply shocks and estimate a homeproduction model. Lubik and Schorfheide (2003) estimate the small open economy extension of the model presented in Section 2 to examine whether the central banks of Australia. FernándezVillaverde and RubioRamírez (2004) use Bayesian estimation techniques to ﬁt a cattle–cycle model to the data. (2004) analyze an open economy model that includes capital accumulation as well as numerous real and nominal frictions. (2000). Adolfson et al.b) for the U. and Otrok (2001). (2005) have been analyzed by Smets and Wouters (2003. Onatski and Williams (2004).S. and de Walque and Wouters (2004) have estimated multicountry DSGE models. Galí and Rabanal (2005) use an estimated DSGE model to study the effect of technology shocks on hours worked. Justiniano and Preston (2004) extend the empirical analysis to situations of imperfect exchange rate passthrough. DeJong et al. Bayesian estimation techniques have also been used in the open economy literature. The literature on likelihoodbased Bayesian estimation of DSGE models began with work by LandonLane (1998). A similar model is ﬁtted by Del Negro (2003) to Mexican data. Schorfheide (2000). Lubik and Schorfheide (2004) estimate the benchmark New Keynesian DSGE model without restricting the parameters to the determinacy region of the parameter space. Variants of the smallscale New Keynesian DSGE model presented in Section 2 have been estimated by Rabanal and RubioRamírez (2005a. An and F. Many central banks are in the process of developing DSGE models along the lines of Smets and Wouters (2003) that can be estimated with Bayesian techniques and used for policy analysis and forecasting. and Schorfheide (2000) considers cashinadvance monetary DSGE models. (2000) estimate a stochastic growth model and examine its forecasting performance.142 S. and Levin et al. Canova (2004) estimates a smallscale New Keynesian model recursively to assess the stability of the structural parameters over time. DeJong and Ingram (2001) study the cyclical behavior of skill accumulation. 2005) both for the U. England. Canada. Models similar to Smets and Wouters (2003) have been estimated by Laforte (2004).S. Lubik and Schorfheide (2006). (2002) estimate a stochastic growth model augmented with a learningbydoing mechanism to amplify the propagation of shocks. Schorfheide models. and the Euro Area. and the Euro Area.
A probability model is considered as discredited by the data if one observes an event that is deemed very unlikely by the model. Let Y rep be a sample of observations of length T that we could have observed in the past or that we might observe in the future. (1995). A quantitative model check can be based on Bayesian pvalues. on the other hand. Posterior Predictive Checks Predictive checks as a tool to assess the absolute ﬁt of a probability model have been advocated.Bayesian Analysis of DSGE Models 143 5. are typically conducted by enlarging the model space and applying Bayesian inference and decision theory to the extended model space. for instance. and has a unimodal density. in books by Gelman et al. 5. Model Evaluation In Section 4 we discussed the estimation of a linearized DSGE model and reported results on the posterior distribution of the model parameters and variance decompositions.2 reviews model posterior odds comparisons. posterior predictive checks have become a valuable tool in applied Bayesian analysis though they have not been used much in the context of DSGE models. Suppose that the test quantity is univariate. We will distinguish the assessment of absolute ﬁt from techniques that aim to determine the ﬁt of a DSGE model relative to some other model. Then one could compute probability of the tail . and Section 5. Section 5. Methods that determine whether actual data lie in the tail of a model’s data distribution potentially favor alternatives that make unreasonably diffuse predictions.3 describes a more elaborate model evaluation based on comparisons between DSGE models and VARs. and Geweke (2005). The ﬁrst approach can be implemented by a posterior predictive model check and has the ﬂavor of a classical hypothesis test.1. Such model checks are controversial from a Bayesian perspective. Relative model comparisons. This section studies various techniques that can be used to evaluate the model ﬁt. by Box (1980). Lancaster (2004). We tacitly assumed that model and prior provide an adequate probabilistic representation of the uncertainty with respect to data and parameters.1 discusses Bayesian model checks. An introduction to Bayesian model checking can be found. nonnegative. Section 5. for instance. Nevertheless. We can derive the predictive distribution of Y rep given the current state of knowledge: p(Y rep  Y ) = p(Y rep  )p(  Y )d (44) Let h(Y ) be a test quantity that reﬂects an aspect of the data that we want to examine.
and calculate h(Y rep ). To obtain draws from the posterior predictive distribution of h(Y rep ) we take every 5. we would expect the actual values of h(Y ) to lie further in the tails of the posterior predictive distribution in the right panels than in the left panels. output growth and lagged output growth. An excellent survey on model comparisons based on posterior probabilities To obtain draws from the unconditional distribution of yt we initialize s0 = 0 and generate 180 observations. the intersections of the solid lines indicate the actual values h(Y ). Since 1 (L) was generated from model 1 (L). whereas under misspeciﬁcation. The observed autocorrelation of output growth in 5 (L) is much larger and the actual correlation between output growth and interest rates is much lower than the draws generated from the posterior predictive distribution. discarding the ﬁrst 100. simulate a sample Y rep of 80 observations9 from the DSGE model conditional on (s) . and output growth and interest rates. Schorfheide event by h(Y rep ) ≥ h(Y ) p(Y rep  Y )dY rep . 9 . the posterior is constructed based on data set 1 (L).2. We use the following data transformations: the correlation between inﬂation and lagged interest rates. Moreover.000th parameter draw of (s) generated with the RWM algorithm. Rather than constructing numerical approximations of the tail probabilities for univariate functions h(·). (45) where x ≥ a is the indicator function that is 1 if x ≥ and zero otherwise. whereas 5 (L) was not. An and F. Each panel of the ﬁgure depicts 200 draws from the posterior predictive distribution in bivariate scatter plots. Posterior Odds Comparisons of DSGE Models The Bayesian framework is naturally geared toward the evaluation of relative model ﬁt. we use a graphical approach to illustrate the model checking procedure in the context of model 1 (L). illustrated in the two right panels of Figure 8. 5. the posterior is obtained from data set 5 (L). Researchers can place probabilities on competing models and assess alternative speciﬁcations based on their posterior odds. depicted in the left panels of Figure 8. A small tail probability can be viewed as evidence against model adequacy. Indeed a visual inspection of the plots provides some evidence in which dimensions 1 (L) is at odds with data generated from a model that includes lags of output in the household’s Euler equation. We consider two cases: in the case of no misspeciﬁcation. lagged inﬂation and current interest rates.144 S.
3. can be found in Kass and Rafterty (1995). even in situations in which all the models under consideration are misspeciﬁed. It is straightforward to verify that under a 0–1 loss function (the loss attached to choosing the wrong model is one).T = i. For concreteness.0 p(Y j =1. i = 1. researchers take a shortcut and use posterior probabilities to justify the selection of a particular model speciﬁcation. denoted by 3 (L) in which prices are nearly ﬂexible. If we are willing to place prior probabilities i. = 5. suppose in addition to the speciﬁcation 1 (L) we consider a version of the New Keynesian model. We plot 200 draws from the posterior predictive distribution of various sample moments.3. Intersections of solid lines signify the observed sample moments. In many instances.4  i) p(Y  j . that is. 4 (46) The key object in the calculation of posterior probabilities is the marginal data density p(Y  i ).0 on the three competing speciﬁcations then posterior model probabilities can be computed by i. which is deﬁned in (39). This 0–1 loss function is an attractive benchmark in situations in which the researcher believes that all the important models are included in the analysis.Bayesian Analysis of DSGE Models 145 FIGURE 8 Posterior predictive check for Model 1 (L). Moreover.0 j) . All subsequent analysis is then conditioned on the chosen model. Posterior model probabilities can be used to weigh predictions from different models. the optimal decision is to select the highest posterior probability model. . However. according to which the central bank does not respond to output at all and 2 = 0. there is a model 4 (L).
)d . We will subsequently consider two numerical approaches: Geweke’s (1999b) modiﬁed harmonic mean estimator and Chib and Jeliazkov’s (2001) algorithm. f( )= −1 (2 )−d/2  V  −1/2 exp −0 5( − ¯ ) V −1 ( − ¯ ) ( − ¯ ) V −1 ( − ¯ ) ≤ F −1 ( ) 2 d × (50) Here ¯ and V are the posterior mean and covariance matrix computed from the output of the posterior simulator. e. Conditional on the choice of f ( ) an obvious estimator is ˆ pG (Y ) = 1 nsim nsim s=1 f ( (s) ) ( (s)  Y )p( −1 (s) ) . f ( ) should be chosen so that the summands are of equal magnitude. d is the dimension of the . 1952) and the model comparison based on posterior odds captures the relative onestepahead predictive performance. To make the numerical approximation efﬁcient. = t =1 ln p(yt  Y t −1 . (49) where (s) is drawn from the posterior p(  Y ). ) )p(  Y t −1 . 1994). The practical difﬁculty in implementing posterior odds comparisons is the computation of the marginal data density. An and F. Phillips (1996) and FernándezVillaverde and RubioRamírez (2004). Geweke (1999b) proposed to use the density of a truncated multivariate normal distribution. .146 S.g.. Moreover. since the logmarginal data density can be rewritten as T ln p(Y  )= t =1 T ln p(yt  Y t −1 . It has been shown under various regularity conditions. (47) where ln p(Y  ) can be interpreted as a predictive score (Good. that posterior odds (or their large sample approximations) asymptotically favor the DSGE model that is closest to the ‘true’ data generating process in the KullbackLeibler sense. Schorfheide the selection of the highest posterior probability model has some desirable properties. Harmonic mean estimators are based on the identity 1 = p(Y ) f( ) p(  Y )d . (  Y )p( ) (48) where f ( ) has the property that f ( )d = 1 (see Gelfand and Dey.
˜  Y ) be the proposal density for the transition from to ˜ . . While the numerator can be easily computed. If the posterior of is in fact normal then the summands in (49) are approximately constant.Bayesian Analysis of DSGE Models 147 parameter vector.  Y ) given the posterior mode value ˜ . F 2 is the cumulative density function of a 2 random d variable with d degrees of freedom. For the output gap rule all four chains lead to estimates of around −196 7 Figure 10 provides a comparison of Geweke’s versus Chib and Jeliazkov’s approximation of the marginal data density for the output gap rule speciﬁcation. (j ) (s) . r ( . The results are summarized in Figure 9. However. ˜ Y) J −1 J j =1 Y) .  Y ) = min 1. the modiﬁed harmonic mean estimator appears to be more reliable if the number of simulations is small.  Y ) was in the description of the algorithm. and ∈ (0. (54) sim where (s) s=1 are sampled draws from the posterior distribution with the J RWM algorithm and (j ) j =1 are draws from q( ˜ . We calculate marginal data densities recursively (as a function of the number of MCMC draws) for the four chains that were initialized at different starting values as discussed in Section 4. Chib and Jeliazkov (2001) use the following equality as the basis for their estimator of the marginal data density: p(Y ) = (  Y )p( ) p(  Y ) (51) The equation is obtained by rearranging the Bayes theorem and has to hold for all . Then the posterior density at the mode can be approximated by ˆ p( ˜  Y ) = n 1 nsim nsim s=1 ( (s) . Y) . let q( . (53) where r ( . Within the RWM Algorithm denote the probability of moving from to by ( . We ﬁrst use Geweke’s harmonic mean estimator to approximate the marginal data density associated with 1 (L)/ 1 (L). 1). ˆ p( ˜  Y ) (52) where we replaced the generic in (51) by the posterior mode ˜ . A visual inspection of the plot suggests that both estimators converge to the same limit point. Moreover. ˆ pCS (Y ) = ( ˜  Y )p( ˜ ) . ˜  Y )q( (˜. the denominator requires a numerical approximation. Thus.
148 S. log marginal data densities are computed recursively with Geweke’s modiﬁed harmonic mean estimator and plotted as a function of the number of draws. An and F. Data 1 (L). For each Markov chain. FIGURE 10 Geweke vs. Log marginal data densities are computed recursively with Geweke’s modiﬁed harmonic mean estimator as well as the Chib–Jeliazkov estimator and plotted as a function of the number of draws. Schorfheide FIGURE 9 Data densities from multiple chains – Model 1 (L). Data 1 (L). . Chib–Jeliazkov data densities – Model 1 (L).
3. can be interpreted as restrictions on a VAR representation. The marginal data density of model 4 (L) is equal to −201 9 and the Bayes factor of model 1 (L) versus model 4 (L) is ‘only’ e 5 . which translates into a Bayes factor (ratio of posterior odds to prior odds) of approximately e 49 in favor of 1 (L). Based on data set 1 (L) we also estimate speciﬁcation 3 (L) in which prices are nearly ﬂexible and speciﬁcation 4 (L) in which the central bank does not respond to output. at least approximately. This mechanism makes it difﬁcult to identify the policy rule coefﬁcients and imposing an incorrect value for 2 is not particularly costly in terms of ﬁt. Hence. The DSGE model implies that when actual output is close to the target ﬂexible price output. Comparison of a DSGE Model with a VAR The notion of potential misspeciﬁcation of a DSGE model can be incorporated in the Bayesian framework by including a more general reference model 0 into the model set.00 exp[48 9] exp[5 2] 1 (L) Notes: The log marginal data densities for the DSGE model speciﬁcations are computed based on Geweke’s (1999a) modiﬁed harmonic mean estimator.Bayesian Analysis of DSGE Models TABLE 4 Log marginal data densities based on Speciﬁcation Benchmark model 1 (L) Model with nearly ﬂexible prices 3 (L) No policy reaction to output 4 (L) 1 (L) 149 ln p(Y  −196 7 −245 6 −201 9 ) Bayes factor versus 1. the speciﬁcation of a prior distribution for the VAR parameter requires careful attention. deviations of output from target coincide with deviations of inﬂation from its target value. The ﬁrst step of the comparison is typically to compute posterior probabilities for the DSGE model and the VAR. Since the VAR parameter space is generally much larger than the DSGE model parameter space. Possible pitfalls are discussed in Sims (2003). as linearized DSGE models. A VAR with a prior that is very diffuse is likely to be rejected even against a misspeciﬁed DSGE model. The marginal data density associated with 3 (L) is −245 6. Given the fairly concentrated posterior of depicted in Figure 1 this result is not surprising. inﬂation will also be close to its target value. 5. In a more general context this phenomenon is often called Lindley’s paradox. which can be used to detect the presence of misspeciﬁcations. We will subsequently present a procedure that allows us to document how the marginal data density of the DSGE model changes as . data set 1 (L) provides very strong evidence against ﬂexible prices. Vice versa. The model comparison results are summarized in Table 4. A natural choice of reference model in dynamic macroeconomics is a VAR.
and the magnitude of the roots of the moving average polynomial. the coefﬁcient matrix = [ 0 . and the T × k matrix X with rows xt . Its accuracy depends on the number of lags p. Schorfheide the crosscoefﬁcient restrictions that the DSGE model imposes on the VAR are relaxed. The posterior computations. The framework has been extended to a model evaluation tool in Del Negro et al. would become signiﬁcantly more cumbersome. p ] . however. yt −p ] . [ut ut ] = (55) Deﬁne the k × 1 vector xt = [1. To construct a DSGEVAR we proceed as follows. Consider a vector autoregressive speciﬁcation of the form yt = 0 + 1 yt −1 + ··· + p yt −p + ut . 10 . An and F. . ∗ ( )= YY ( )− YX ( ) −1 XX ( ) XY ( ) (56) This approximation is typically not exact because the state–space representation of the linearized DSGE model generates moving average terms. Thus the VAR can be written as Y = X + U . We will refer to the latter benchmark model as DSGEVAR and discuss an identiﬁcation scheme that allows us to construct structural impulse response functions for the vector autoregressive speciﬁcation against which the DSGE model can be evaluated. We will document below that four lags are sufﬁcient to generate a fairly precise approximation of the model 1 (L).10 In principle one could start from a VARMA model to avoid the approximation error. . Building on work by Ingram and Whiteman (1994) the DSGEVAR approach of Del Negro and Schorfheide (2004) was designed to improve forecasting and monetary policy analysis with VARs. the T × n matrices Y and U composed of rows yt and ut . XY ( )= D [xt yt ] A VAR approximation of the DSGE model can be obtained from restriction functions that relate the DSGE model parameters to the VAR parameters. (2006) and used to assess the ﬁt of a variant of the Smets and Wouters (2003) model. If the data favor the VAR over the DSGE model then it becomes important to investigate further the deﬁciencies of the structural model. This can be achieved by comparing the posterior distributions of interesting population characteristics such as impulse response functions obtained from the DSGE model and from a VAR representation that does not dogmatically impose the DSGE model restrictions. Let D [·] be the expectation under DSGE model and deﬁne the autocovariance matrices XX ( )= D [xt xt ]. ∗ ( )= −1 XX ( ) XY ( ). 1 .150 S. yt −1 .
. is a hyperparameter that scales the prior covariance matrix. Bayesian analysis of this model requires the speciﬁcation of a prior distribution for the DSGE model parameters.11 The prior distribution can be interpreted as a posterior calculated from a sample of T observations generated from the DSGE model with parameters . n (58) −1 1 ( ). (2006). = ∗ ( )+ (57) and capture deviations from the restriction functions The matrices ∗ ( ) and ∗ ( ). In the limit the VAR is estimated subject to the restrictions (56). which is emphasized in Del Negro et al. T − k. e. ∼ W (1 + )T b( b( ). (1 + )T − k.Bayesian Analysis of DSGE Models 151 In order to account for potential misspeciﬁcation of the DSGE model it is assumed that there is a vector and matrices and such that the data are generated from the VAR in (55) with the coefﬁcient matrices = ∗ ( )+ . ∼ W T ∗ ∗ ( ). )p (  Y ) (59) The subscript indicates the dependence of the posterior on the hyperparameter. their setup did not allow for the computation of a posterior distribution for . Rather than specifying a prior in terms of and it is convenient to specify it in terms of and conditional on . where W denotes the inverted Wishart distribution. and the misspeciﬁcation matrices. The prior distribution is proper provided that T ≥ k + n. (60) 11 Ingram and Whiteman (1994) constructed a VAR prior from a stochastic growth model to improve the forecast performance of the VAR. The joint posterior density of VAR and DSGE model parameters can be conveniently factorized as p ( . . T ⊗ XX ( ) −1 . It is straightforward to show. Zeller (1971). that the posterior distribution of and is also of the inverted Wishart normal form: Y. n XX ( ). . The prior is diffuse for small values of and shifts its mass closer to the DSGE model restrictions as −→ ∞. p( ). However. We assume  ∼  . . ∼ Y. see Del Negro and Schorfheide (2004). ⊗( T ) + X X )−1 .VAR. It has the property that its density is approximately proportional to the Kullback–Leibler discrepancy between the VAR approximation of the DSGE model and the .g. Y) = p ( .  Y .
the values that respect the crossequation restrictions of the DSGE model. the closer the posterior mean of the VAR parameters is to ∗ ( ) and ∗ ( ). An and F. it is important to consider a datadriven procedure to determine .152 S. Schorfheide b( where ) and b( ) are the given by XX ( b( )= )= 1+ )+ 1 XX 1+ T −1 1+ YX ( XY + 1 XY 1+ T b( 1 ( T (1 + )T YY ( )+Y Y)−( T ) + Y X) )+X Y) ×( T XX ( ) + X X )−1 ( T XY ( Hence the larger the weight of the prior. (2006) emphasize that the posterior of provides a measure of ﬁt for the DSGE model: high posterior probabilities for large . On the other hand. Del Negro et al. A natural criterion for the choice of in a Bayesian framework is the marginal data density p (Y ) = p (Y  )p( )d (61) For computational reasons we restrict the hyperparameter to a ﬁnite grid . If one assigns equal prior probability to each grid point then the normalized p (Y )’s can be interpreted as posterior probabilities for . Since the empirical performance of the DSGEVAR procedure crucially depends on the weight placed on the DSGE model restrictions. if = (n + k)/T . The paper also shows that in large samples the resulting estimator of can be interpreted as a Bayesian minimum distance estimator that projects the VAR coefﬁcient estimates onto the subspace generated by the restriction functions (56). The marginal posterior density of can be obtained through the marginal likelihood p (Y  ) =  T XX ( ) + X X − 2 (1 + )T XX ( n b( )− (1+ )T −k 2  T × (2 )−nT /2 2 2 )− 2  T n i=1 n ∗( )− T −k 2 n((1+ )T −k) 2 n( T −k) 2 [((1 + )T − k + 1 − i)/2] n i=1 [( T − k + 1 − i)/2] A derivation is provided in Del Negro and Schorfheide (2004). then the posterior mean is close to the OLS estimate (X X )−1 X Y .
Del Negro and Schorfheide (2004) proposed to construct as follows. The initial tr impact of t on yt in the VAR. (64) where ∗ ( ) is lower triangular and ∗ ( ) is orthonormal. the shortrun responses of the VAR with those from the DSGE model.Bayesian Analysis of DSGE Models 153 values of indicate that the model is well speciﬁed and a lot of weight should be placed on its implied restrictions. . Deﬁne ˆ = argmax p (Y ) ∈ (62) If p (Y ) peaks at an intermediate value of . and is an orthonormal tr is the Cholesky decomposition of matrix that is not identiﬁable based on the likelihood function associated with (55). which we represent by ut = tr t (63) . say between 0. is given by yt t VAR = tr (65) To identify the DSGEVAR. The rotation matrix is chosen so that in absence of misspeciﬁcation the DSGE’s and the DSGEVAR’s impulse responses to all shocks approximately coincide. the VAR given in (55) has been speciﬁed in terms of reduced form disturbances ut . Using a QR factorization. To the extent that misspeciﬁcation is mainly in the dynamics. the onestepahead forecast errors ut are functions of the structural shocks t . the identiﬁcation procedure can be interpreted as matching. at least qualitatively. Let A0 ( ) be the contemporaneous impact of t on yt according to the DSGE model. So far.5 and 2. the initial response of yt to the structural shocks can be can be uniquely decomposed into yt t DSGE = A0 ( ) = ∗ tr ( ) ∗ ( ). we maintain the triangularization of its covariance matrix and replace the rotation in (65) with the function ∗ ( ) that appears in (64). According to the DSGE model. on the other hand. then a comparison between DSGEVAR( ˆ ) and DSGE model impulse responses can yield important insights about the misspeciﬁcation of the DSGE model. as opposed to the covariance matrix of innovations. An impulse response function comparison requires the identiﬁcation of structural shocks in the context of the VAR. The estimation of the DSGEVAR can be implemented as follows.
154 S. which is representative for the shapes found in empirical applications in Del Negro and Schorfheide (2004) and Del Negro et al. For each draw (s) generate a pair (s) . The value = 1 00 has the highest likelihood. Use Geweke’s modiﬁed harmonic mean estimator to obtain a numerical approximation of p (Y ). Schorfheide MCMC Algorithm for DSGEVAR 1. whereas the second row corresponds to the DSGEVAR(∞). An and F. Use the RWM algorithm to generate draws (s) from the marginal posterior distribution p (  Y ). (s) . 5. All the results reported subsequently are based on a DSGEVAR with p = 4 lags. 2. The ﬁrst row reports the marginal data density associated with the state space representation of the DSGE model. 1 (L) 1 (L) DSGEVARs 5 (L) −196 66 −196 88 −198 87 −206 57 −209 53 −215 06 −231 20 −245 62 −244 54 −241 95 −238 59 −239 40 −241 81 −253 61 . (2006). the marginal data densities are increasing as a function of . compute the orthonormal matrix (s) = ∗ ( ) as described above. 5. 1. This misspeciﬁcation is captured in the inverse U shape of the marginal data density function. With respect to data set 5 (L) the DSGE model is misspeciﬁed. the two values are indeed quite close. The ﬁrst step of our analysis is to construct a posterior distribution for the parameter . The marginal data TABLE 5 Log marginal data densities for Speciﬁcation DSGE Model DSGEVAR = ∞ DSGEVAR = 5 00 DSGEVAR = 1 00 DSGEVAR = 75 DSGEVAR = 50 DSGEVAR = 25 Notes: See Table 4. For = ∞ the misspeciﬁcation matrices estimate the VAR by imposing the restrictions = ∗ ( ) and = ∗ ( ). by sampling from the W − distribution. If the VAR approximation of the DSGE model were exact. Table 5 reports log marginal data densities for the DSGEVAR as a function of for data sets 1 (L) and 5 (L). then the values in the ﬁrst and second row of Table 5 would be identical. 3. We assume that lies on the grid = 25. For data set 1 (L). We now implement the DSGEVAR procedure for 1 (L) based on artiﬁcially generated data. Moreover. indicating that there is no evidence of misspeciﬁcation and that it is best to dogmatically impose the DSGE model restrictions. ∞ and assign equal probabilities to each grid and are zero and we point. 75. which has been directly generated from the state space representation of 1 (L). Moreover.
the = ∞ and the = ˆ DSGEVAR. In principle.Bayesian Analysis of DSGE Models 155 densities drop substantially for ≥ 5 and ≤ 0 5. Figure 11 depicts posterior mean impulse responses for the state–space representation of the DSGE model as well as the DSGEVAR(∞). Data 5 (L). there are three different sets of impulse responses to be compared: responses from the state–space representation of the DSGE model. and DSGEVAR( = ∞) – Model 1 (L). DSGEVAR( = ∞) responses: posterior mean (dashed) and pointwise 90% probability bands (dotted). DSGE. Moreover. In both FIGURE 11 Impulse responses. these impulse responses can either be compared based on the same parameter values or their respective posterior estimates of the DSGE model parameters. . DSGE model responses computed from state–space representation: posterior mean (solid). In order to assess the nature of the misspeciﬁcation for 5 (L) we now turn to the impulse response function comparison.
we take the upper and lower bound of these probability intervals and shift them according to the posterior mean of the = ∞ response. and interest rates satisfy the following relationships in response . inﬂation returns quickly to its steadystate level after a contractionary policy shock. The discrepancy between the posterior mean responses (solid and dashed lines) indicates the magnitude of the error that is made by approximating the state–space representation of the DSGE model by a fourthorder VAR. The (dotted) 90% probability bands reﬂect uncertainty with respect to the discrepancy between the = ∞ and ˆ responses. Unlike in the DSGEVAR(∞). According to the loglinearized DSGE model output. A brief description of the computation can clarify the interpretation. Except for the response of output to the government spending shock. To obtain the dotted bands in the ﬁgure. we can also ask to what extent are the optimality conditions that the DSGE model imposes satisﬁed by the DSGEVAR( ˆ ) responses. According to the VAR approximation of the DSGE model.156 S. indicating that the approximation error is small. An and F. on the other hand. For each draw of from the ˆ DSGEVAR posterior we compute the ˆ and the = ∞ response functions. namely. inﬂation. The DSGEVAR( ˆ ) response of inﬂation. Schorfheide cases we use the same posterior distribution of . calculate their differences. The (dotted) bands in Figure 11 depict pointwise 90% probability intervals for the DSGEVAR(∞) and reﬂect posterior parameter uncertainty with respect to . Roughly speaking. is transformed from the – space into impulse response functions because they are easier to interpret. Both sets of responses are constructed from the ˆ posterior of . Rather than looking at the dynamic responses of the endogenous variables to the structural shocks. and the reversion to the steadystate is much slower. To assess the misspeciﬁcation of the DSGE model we compare posterior mean responses of the = ∞ (dashed) and ˆ (solid) DSGEVAR in Figure 12. the interest rate falls below steadystate in period four and stays negative for several periods. however. In a general equilibrium model a misspeciﬁcation of the households’ decision problem can have effects on the dynamics of all the endogenous variables. The discrepancy. has a slight hump shape. the ﬁgure answers the question: to what extent do the ˆ estimates of the VAR coefﬁcients deviate from the DSGE model restriction functions ∗ ( ) and ∗ ( ). While the relaxation of the DSGE model restrictions has little effect on the propagation of the technology shock. the inﬂation and interest rate responses to a monetary policy shock are markedly different. the one obtained from the DSGEVAR(∞). the DSGE and DSGEVAR(∞) responses are virtually indistinguishable. and construct probability intervals of the differences.
Data 5 (L). DSGEVAR( = ∞) posterior mean responses (dashed). DSGEVAR( = 1) posterior mean responses (solid). to the shock R . and DSGEVAR( = 1) – Model 1 (L). DSGEVAR( = ∞).t R Rt −1 − yt ˆ − (1 − ˆ 2 yt − (1 − (68) Figure 13 depicts the path of the righthand side of Equations (66) to (68) in response to a monetary policy shock. Pointwise 90% probability bands (dotted) signify shifted probability intervals for the difference between = ∞ and = 1 responses. Based on draws from the joint posterior of the DSGE and VAR parameters we can ﬁrst calculate identiﬁed .Bayesian Analysis of DSGE Models 157 FIGURE 12 Impulse responses.t : 0 = yt − ˆ = Rt − t [yt +1 ] 1 + (Rt − t [ ˆ t +1 ] R) 1 ˆt t [ t +1 ]) (66) (67) R) 0 = ˆt − R .
The dashed lines show the posterior mean responses according to the state–space representation of the DSGE model. and the solid lines depict DSGEVAR responses. Schorfheide (2000) proposed a lossfunctionbased evaluation framework for (multiple) DSGE models that . Schorfheide FIGURE 13 Impulse responses. While this section focused mostly on the assessment of a single DSGE model. (2006) use the DSGEVAR framework also to compare multiple DSGE models. DSGEVAR( = ∞). and in a second step use the DSGE model parameters to calculate the wedges in the Euler equation. Panel (2. and interest rate.1) indicates a substantial violation of the consumption Euler equation.158 S. Data 5 (L). DSGEVAR responses: posterior mean (solid) and pointwise 90% probability bands (dotted). The top three panels of Figure 13 show that both for the DSGE model as well as the DSGEVAR(∞) the three equations are satisﬁed. The bottom three panels of the ﬁgure are based on the DSGEVAR( ˆ ). inﬂation. This ﬁnding is encouraging for the evaluation strategy since the data set 5 (L) was indeed generated from a model with a modiﬁed Euler equation. the price setting equation. which relaxes the DSGE model restrictions. at least for the posterior mean. and DSGEVAR( = 1) – Model 1 (L). DSGE model responses: posterior mean (dashed). VAR responses to obtain the path of output. and the monetary policy rule. Del Negro et al. An and F. While the price setting relationship and the monetary policy rule restriction seem to be satisﬁed.
The vector st has been deﬁned in Section 2. the linear Kalman ﬁlter cannot be used to compute the likelihood function. . by generating one . constructs a posterior distribution for population characteristics of interest such as autocovariances and impulse responses. We follow their approach and use the particle ﬁlter for DSGE model 1 solved with a secondorder perturbation method. popularized in the calibration literature. Recently FernándezVillaverde and RubioRamírez (2005) use the ﬁlter to construct the likelihood for DSGE model solved with a projection method. This prediction is evaluated under a loss function and the risk is calculated under an overall posterior distribution that averages the predictions of the DSGE models and the reference model according to their posterior probabilities. from the initial distribution p(s0  ). as special cases. The evaluation of the likelihood function can be implemented with a particle ﬁlter. i=1 Hence one can draw N particles from p st  Y t −1 . In economics. dst −1 ≈ 1 N N sti ˜ N i=1 from p st  sti−1 . By induction. (2002) provide an excellent survey. the particle ﬁlter has been applied to analyze the stochastic volatility models by Pitt and Shephard (1999) and Kim et al.Bayesian Analysis of DSGE Models 159 augments potentially misspeciﬁed DSGE models with a more general reference model. 2) Prediction: Draw onestepahead forecasted particles p st  Y t −1 . . also known as a sequential Monte Carlo ﬁlter. t = 1. = p (st  st −1 . (1998). We use Y to denote the × n matrix with rows yt . A brief description of the procedure is given below. particle from p st  sti−1 . which approximate p st −1  Y t −1 . N . and then examines the ability of the DSGE models to predict the population characteristics. Note that p st  Y t −1 . Arulampalam et al. in period t we start with the particles N sti−1 i=1 . Instead. i = 1. ) p st −1  Y t −1 . NONLINEAR METHODS For a nonlinear/nonnormal state–space model. . for each i. numerical methods have to be used to integrate the latent state vector. 6. This lossfunctionbased approach nests DSGE model comparisons based on marginal data densities as well as assessments based on a comparison of model moments to sample moments. . .4. Particle Filter i 1) Initialization: Draw N particles s0 . (1993) and Kitagawa (1996) are early contributors to this literature. Gordon et al.
where after a few iterations. . which amounts to updating the probability weights assigned to the particles N sti i=1 . . all but one particle will have negligible weight. An and F. (69) p yt  Y t −1 . We begin by computing the nonnormalized importance weights ˜ ˜ ˜ ti = p yt  sti .N The resulting sample is in fact an iid sample from the discretized density of p(st  Y t . . approximates12 the N 4) Resampling: We now generate a new set of particles sti i=1 by resampling with replacement N times from an approximate discrete N ˜ representation of p st  Y t . In the remainder of this section we will refer to these parameters as “true” values as opposed to “pseudotrue” values to 12 The sequential importance sampler (SIS) is a Monte Carlo method which utilized this aspect. ˜ i N t i=1 j and note that the importance sampler updated density p st  Y t . = p yt  st . i = 1. ) and hence is equally weighted. p st  Y t −1 . ≈ t =1 1 N N ˜ ti i=1 To compare results from ﬁrst and secondorder accurate DSGE model solutions we simulated artiﬁcial data of 80 observations from the quadratic approximation of model 1 with parameter values reported in Table 3 under the heading 1 (Q ). p st  Y t −1 . dst ≈ 1 N N ˜ ti i=1 (70) Now deﬁne the normalized weights i t = ˜ ti N j =1 ˜t sti . The denominator in (69) can be approximated by p yt  Y t −1 . . ti i=1 so that ˜ Pr sti = sti = i t.160 S. Schorfheide 3) Filtering: The goal is to approximate p st  Y t . 5) Likelihood Evaluation: According to (70) the log likelihood function can be approximated by T N ln (  Y ) = ln p(y1  ) + T t =2 ln p yt  Y t −1 . given by sti . = p yt  st . . but it is well documented that it suffers from a degeneracy problem.
For a good approximation of the prediction error distribution. where x is the steadystate of xt . . Second.2 to match the average output growth rate. Conﬁguration of the Particle Filter There are several issues concerning the practical implementation of the particle ﬁlter. 13 . and z . (Q ) . especially enough particles to capture the tails of Without the measurement error two complications arise: since p(yt  st ) degenerates to a pointmass and the distribution of st is that of a multivariate noncentral 2 the evaluation of p(yt  Y t −1 ) becomes difﬁcult. 1/g is chosen as . g . 1. In the linear case. .55. Moreover. gt . The implied quadratic adjustment cost coefﬁcient. and 3. Other exogenous process parameters. p (s0  ). there are some exceptions. First. We also make monetary policy less responsive to the output gap by setting 2 = 125. we have to choose the number of particles.33. the computation of p(st  Y t ) requires the solution of a system of quadratic equations. These true parameter values by and large resemble the parameter values that have been used to generate data from the loglinear DSGE model speciﬁcations. g . we need a scheme to draw from the initial state distribution. which implies a steadystate markup of 11% that is consistent with the estimates of Basu (1995).Bayesian Analysis of DSGE Models 161 be deﬁned later. . and inﬂation between the artiﬁcial data and the real U. is 53.t = (0) j + (1) j wt + wt (2) j wt (71) where wt = [xt −1 . which implies that the steadystate consumption amounts to 85% of output. whose standard deviation is set as 20% of that of each observation. z . However.t can be expressed as xj . it is desirable to have many particles. We generate x0 by drawing 0 from its unconditional distribution (the law of motion for t is linear) and setting x−1 = x. a measurement error is introduced to each measurement equation. it is straightforward to calculate the unconditional distribution of st associated with the vector autoregressive representation (33). data. and (A) are chosen as . interest rate. is set to 0. r (A) .85.t . The law of motion ˆ ˆ for the endogenous state variables xj . and zt . For the secondorder approximation we rewrite the state transition equation (37) as follows. For computational convenience.0. data.1.1. R . t ] . which implies less price stickiness than in the linear case.S. is chosen to be . These values are different from the mean of the historical observations because in the nonlinear version of the DSGE model means differ from steady states. where t is composed of the exogenous processes R .S. t ] . The degree of imperfect competition.13 6.68. Decompose st = [xt . are chosen so that the second moments are matched to the U. The slope coefﬁcient of the Phillips curve.
First. which are obtained by ﬁnding the mode of the linear likelihood using 3. Schorfheide p(st  Y t ). For brevity. We implement most of the procedure in MATLAB (2005) so that we can exploit the symbolic toolbox to solve the DSGE model. Linear methods are more than 200 times faster: 1. Recall that we had introduced a reducedform Phillips curve parameter in (32) because and cannot be identiﬁed with the loglinearized DSGE model. An and F.000 particles were enough to get stable evalutaions of the likelihood given the size of the measurement errors. the particle ﬁlter can be readily implemented on a good desktop computer. Figure 14 shows the loglikelihood proﬁles along each structural parameter dimension. In our application. Two features are noticeable in this comparison. the resampling will not work well. However. In our implementation. The parameter values for and 1/g are ﬁxed at their true values because they do not enter the linear likelihood.000 particles in 1 h and 40 min (6. we evaluate the linear likelihood around the pseudotrue parameter values. The differences between the peaks are most pronounced for the steadystate parameters r (A) and (A) . we will refer to the likelihood obtained from the ﬁrstorder (secondorder) accurate solution of the DSGE model as linear (quadratic) likelihood. It is natural to evaluate the quadratic likelihood function in the neighborhood of the true parameter values given in Table 3. so we can call it as a function in MATLAB.162 S. the stratiﬁed resampling scheme proposed by Kitagawa (1996) is applied. while the linear loglikelihood attains its maximum around the pseudotrue parameter values. Even though the estimation procedure involves extensive random sampling. It is optimal in terms of variance in the class of unbiased resampling schemes. Moreover.000 draws with 40. but it takes too much time to evaluate the likelihood function using the particle ﬁlter. Based on a sample of 80 observations we can generate 1. 6. they differ if the model is solved by a secondorder approximation. the number of particles affects the performance of the resampling algorithm. we found that 40. A Look at the Likelihood Function We will begin our analysis by studying proﬁles of likelihood functions. If the number of particles is too small.000 draws are generated in 24 sec in our Matlab routines and 3 sec in our GAUSS routines. For some parameters . the quadratic loglikelihood peaks around the true parameter values. The ﬁltering step is implemented as FORTRAN mex library.000 observations.2. If the measurement errors in the conditional distribution p(yt  st ) are small.0 sec per draw) on the AMD64 3000+ machine with 1 GB RAM. While in the linearized model steady states and longrun averages coincide. more particles are needed to obtain an accurate approximation of the likelihood function and to ensure that the posterior weights ti do not assign probability one to a single particle.
.Bayesian Analysis of DSGE Models 163 FIGURE 14 Linear vs. Vertical lines signify true (dotted) and pseudotrue (dasheddotted) values. Data Set 1 (Q ).000 particles are used. 40. Likelihood proﬁle for each parameter: 1 (L)/Kalman ﬁlter (dashed) and 1 (Q )/particle ﬁlter (solid). quadratic approximations: likelihood proﬁles.
In both cases we use the same prior distribution reported in Table 3. which . is constant along dashed lines. As noted before.05 is placed on . g does not enter the linear version of the model and hence the loglikelihood proﬁle along this dimension is ﬂat. The right panel of Figure 15 indicates that the iso. the loglikelihood is slightly sloped in 1/g = c/y dimension. A beta prior with mean . In the quadratic approximation.164 S. however. which implies that the nonlinear approach is able to extract more information on the structural parameters from the data. Unlike in the analysis of the likelihood function we now substitute the adjustment cost parameter with the Phillipscurve parameter in the quadratic approximation of the DSGE model.3.lines intersect with the contours of the quadratic likelihood function. An and F. 40. the linear likelihood is ﬂat for the values of and that imply a constant . 6. Schorfheide FIGURE 15 Linear vs. Contours of likelihood (solid) for 1 (L) and 1 (Q ). quadratic approximations: Likelihood contours. Large dot indicates true and pseudotrue parameter value. the quadratic approximation can identify some structural parameters that are unidentiﬁable under the loglinearized model. Data set 1 (Q ). our sample of 80 observations is too short to obtain a sharp estimate of the two parameters.1 and standard deviation 0. the quadratic loglikelihood function is more concave than the linear one. Moreover.space. which suggests that and are potentially separately identiﬁable. The contours of the linear likelihood trace out iso. For instance.lines.000 particles are used. This is illustrated in Figure 15. it appears that the monetary policy parameter such as 1 can be more precisely estimated with the quadratic approximation. The Posterior We now compare the posterior distributions obtained from the linear and nonlinear analysis. which depicts the linear and quadratic likelihood contours in . However.
In their analysis the nonlinear solution combined with the particle ﬁlter delivers a substantially better ﬁt of the model to the data as measured by the marginal data density. we evaluate the Hessian to be used in the RWM algorithm at the (linear) mode without ﬁxing and 1/g . and 1/g . We use the RWM algorithm to generate draws from the posterior distributions associated with the linear and quadratic approximations of the DSGE model. Note that 1 − 1/g is the steadystate government spending–output ratio. Our simulation results with respect to linear versus nonlinear estimation are in line with the ﬁndings reported in FernándezVillaverde and RubioRamírez (2005) for a version of the neoclassical stochastic growth model.05. for most of our parameters. While.25 (quadratic) to target an acceptance rate of about 30%. respectively. Conditional on this parameter is not identiﬁable under the linear approximation and hence its posterior is not updated. This Hessian is used for both the linear and the nonlinear analysis. The draws tend to be more concentrated as we move from prior to posterior. which imply a Bayes factor of about e 8 in favor of the quadratic approximation.5 (linear) and .000 draws from each distribution are generated and every 500th draw is plotted. which is consistent with the positive difference between “true” and “pseudotrue” values of these parameters. and quadratic posterior distribution.Bayesian Analysis of DSGE Models 165 roughly covers micro evidences of 10–15% markup.1 is used for 1/g . ﬁxed at their true values. the quadratic posterior of is markedly different from the prior as it concentrates around 0. 100.85 and standard deviation . Indeed. After that. both for simulated as well . The parameter does. We use scaling factors . The quadratic posterior mean of 1 is larger than the linear posterior mean and closer to the true value. The quadratic posterior means for the steadystate parameters r (A) and (A) are also greater than the corresponding linear posterior means. This result suggests that 1 (Q ) exhibits nonlinearities that can be detected by the likelihoodbased estimation methods. affect the secondorder terms that arise in the quadratic approximation of the DSGE model. linear posterior. there is a clear negative correlation between and according to the quadratic posterior. so that the inverse Hessian reﬂects the prior variance of the additional parameters. Moreover. The Markov chains are initialized in the neighborhood of the pseudotrue and true parameter values. Now consider the parameter that determines the demand elasticity for the differentiated products. Table 6 reports the log marginal data densities for our linear ( 1 (L)) and quadratic ( 1 (Q )) approximations of the DSGE model based on Data Set 1 (Q ). We ﬁrst compute the posterior mode for the linear speciﬁcation with the additional parameters. linear and quadratic posteriors are quite similar. and hence a beta prior with mean 0. The log marginal likelihoods are −416 06 for 1 (L) and −408 09 for 1 (Q ). however. Figures 16 and 17 depict the draws from prior. there are a few exceptions.
quadratic approximation I. . Intersections of solid and dotted lines signify true and pseudotrue parameter values.000 draws from the prior and posterior distributions. An and F. 100.000 particles are used. Data set 1 (Q ). Every 500th draw is plotted. 40. Schorfheide FIGURE 16 Posterior draws: linear vs.166 S.
Bayesian Analysis of DSGE Models 167 FIGURE 17 Posterior draws: Linear vs. quadratic approximation II. See Figure 16. .
Moreover. seminar participants at Columbia University. Lack of identiﬁcation of structural parameters is often difﬁcult to detect since the mapping from the structural form of the DSGE model into a state–space representation is highly nonlinear and creates a challenge for scientiﬁc reporting as audiences are typically interested in disentangling information provided by the data from information embodied in the prior. Thomas Lubik. 7. This paper has surveyed the tools used in this literature and illustrated their performance in the context of artiﬁcial data.00 1 (Q ) −416 06 −408 09 as actual data. although relatively small in magnitude. ACKNOWLEDGMENTS Part of the research was conducted while Schorfheide was visiting the Research Department of the Federal Reserve Bank of Philadelphia. CONCLUSIONS AND OUTLOOK There exists by now a large and growing body of empirical work on the Bayesian estimation and evaluation of DSGE models. many challenges remain. We thank Herman van Dijk and Gary Koop for inviting us to write this survey paper for Econometric Reviews. linear solution 1 (L) Benchmark model.168 S. Schorfheide 1 (Q ) TABLE 6 Log marginal data densities based on Speciﬁcation Benchmark model. may have important effects on the moments of the model. the authors point out that the differences in terms of point estimates. The views expressed here are those of the authors and do not necessarily reﬂect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. Nevertheless. Model size and dimensionality of the parameter space pose a challenge for MCMC methods. Georg Strasser. An and F. Jesús FernándezVillaverde. We also thank our discussants as well as Marco Del Negro. techniques to estimate DSGE models solved with nonlinear methods have become implementable thanks to advances in computing technology. Juan RubioRamírez. While most of the existing empirical work is based on linearized models. ln p(Y  1) Bayes factor vesus exp[7 97] 1. and . Hence it is important to develop methods that incorporate potential model misspeciﬁcation in the measures of uncertainty constructed for forecasts and policy recommendations. for whose hospitality he is grateful. quadratic solution 1 (Q ) Notes: See Table 4. Model misspeciﬁcation is and will remain a concern in empirical work with DSGE models despite continuous efforts by macroeconomists to develop more adequate models.
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