Methods for Applied Macroeconomic

Research

c
Fabio Canova °
ICREA, Universitat Pompeu Fabra, CREI and CEPR
version 5.0

November 13, 2005

Contents

Chapter 1: Preliminaries 1
1.1 Stochastic Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Concepts of Convergence . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2.1 Almost sure (a.s.) convergence . . . . . . . . . . . . . . . . . . 3
1.2.2 Convergence in Probability . . . . . . . . . . . . . . . . . . . . . 4
1.2.3 Convergence in Lq -norm. . . . . . . . . . . . . . . . . . . . . . . 6
1.2.4 Convergence in Distribution . . . . . . . . . . . . . . . . . . . . 7
1.3 Time Series Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.4 Law of Large Numbers . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.4.1 Dependent and Identically Distributed Observations . . . . . 14
1.4.2 Dependent and Heterogeneously Distributed Observations . 15
1.4.3 Martingale Difference Process . . . . . . . . . . . . . . . . . . . 16
1.5 Central Limit Theorems . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
1.5.1 Dependent and Identically Distributed Observations . . . . . 17
1.5.2 Dependent Heterogeneously Distributed Observations . . . . 18
1.5.3 Martingale Difference Observations . . . . . . . . . . . . . . . . 18
1.6 Elements of Spectral Analysis . . . . . . . . . . . . . . . . . . . . . . . 19

Chapter 2: DSGE Models, Solutions and Approximations 27

2.1 Few useful models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
2.1.1 A basic Real Business Cycle (RBC) Model . . . . . . . . . . . 28
2.1.2 Heterogeneous agent models . . . . . . . . . . . . . . . . . . . . 35
2.1.3 Monetary Models . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
2.2 Approximation methods . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
2.2.1 Quadratic approximations . . . . . . . . . . . . . . . . . . . . . . 45
2.2.2 Discretization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
2.2.3 Log linear Approximations . . . . . . . . . . . . . . . . . . . . . 51
2.2.4 Second order approximations . . . . . . . . . . . . . . . . . . . . . . 60
2.2.5 Parametrizing expectations . . . . . . . . . . . . . . . . . . . . . 62
2.2.6 A Comparison of methods . . . . . . . . . . . . . . . . . . . . . 65

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Chapter 3: Extracting and Measuring Cyclical Information 67

3.1 Statistical Decompositions . . . . . . . . . . . . . . . . . . . . . . . . . 69
3.1.1 Traditional methods . . . . . . . . . . . . . . . . . . . . . . . . . 69
3.1.2 Beveridge-Nelson (BN) decomposition . . . . . . . . . . . . . . 69
3.1.3 Unobservable Components (UC) decompositions . . . . . . . 72
3.1.4 Regime shifting decomposition . . . . . . . . . . . . . . . . . . . 75
3.2 Hybrid Decompositions . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
3.2.1 The Hodrick and Prescott (HP) Filter . . . . . . . . . . . . . . 79
3.2.2 Exponential smoothing (ES) filter . . . . . . . . . . . . . . . . . 86
3.2.3 Moving average (MA) filters . . . . . . . . . . . . . . . . . . . . 88
3.2.4 Band Pass (BP) filters . . . . . . . . . . . . . . . . . . . . . . . . 89
3.3 Economic Decompositions . . . . . . . . . . . . . . . . . . . . . . . . . . 95
3.3.1 Blanchard and Quah (BQ) Decomposition . . . . . . . . . . . 95
3.3.2 King, Plosser Stock and Watson (KPSW) Decomposition . 97
3.4 Time Aggregation and Cycles . . . . . . . . . . . . . . . . . . . . . . . 99
3.5 Collecting Cyclical Information . . . . . . . . . . . . . . . . . . . . . . 100

Chapter 4: VAR Models 105

4.1 The Wold theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
4.2 Specification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
4.2.1 Lag Length 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
4.2.2 Lag Length 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.2.3 Nonlinearities and nonnormalities . . . . . . . . . . . . . . . . . 116
4.2.4 Stationarity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
4.2.5 Breaks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
4.3 Moments and parameter estimation of a VAR(q) . . . . . . . . . . . 119
4.3.1 Companion form representation . . . . . . . . . . . . . . . . . . 119
4.3.2 Simultaneous equations format . . . . . . . . . . . . . . . . . . 121
4.4 Reporting VAR results . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
4.4.1 Impulse responses . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
4.4.2 Variance decomposition . . . . . . . . . . . . . . . . . . . . . . . 124
4.4.3 Historical decomposition . . . . . . . . . . . . . . . . . . . . . . 125
4.4.4 Distribution of Impulse Responses . . . . . . . . . . . . . . . . 125
4.4.5 Generalized Impulse Responses . . . . . . . . . . . . . . . . . . 130
4.5 Identification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
4.5.1 Stationary VARs . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
4.5.2 Nonstationary VARs . . . . . . . . . . . . . . . . . . . . . . . . . 137
4.5.3 Alternative identification schemes . . . . . . . . . . . . . . . . . 139
4.6 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
4.7 Validating DSGE models with VARs . . . . . . . . . . . . . . . . . . . 151
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Chapter 5: GMM and Simulation Estimators 157

5.1 Generalized Method of Moment and other standard estimators . . 158
5.2 IV estimation in a linear model . . . . . . . . . . . . . . . . . . . . . . 161
5.3 GMM Estimation: An overview . . . . . . . . . . . . . . . . . . . . . . 167
5.3.1 Asymptotics of GMM estimators . . . . . . . . . . . . . . . . . 168
5.3.2 Estimating the Covariance Matrix . . . . . . . . . . . . . . . . 170
5.3.3 Optimizing the Asymptotic covariance matrix . . . . . . . . . 174
5.3.4 Sequential GMM Estimation . . . . . . . . . . . . . . . . . . . . 175
5.3.5 Two-Step Estimators . . . . . . . . . . . . . . . . . . . . . . . . . 176
5.3.6 Hypotheses Testing . . . . . . . . . . . . . . . . . . . . . . . . . . 177
5.4 GMM estimation of DSGE models . . . . . . . . . . . . . . . . . . . . 181
5.4.1 Some Applied tips . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
5.5 Simulation Estimators . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
5.5.1 The General Problem . . . . . . . . . . . . . . . . . . . . . . . . 188
5.5.2 Simulated Method of Moments Estimator . . . . . . . . . . . 191
5.5.3 Simulated Quasi-Maximum Likelihood/ Indirect Inference . 192
5.5.4 Matching impulse responses . . . . . . . . . . . . . . . . . . . . . . . 196

Chapter 6: Likelihood methods 201

6.1 The Kalman filter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
6.2 The Prediction error decomposition of likelihood . . . . . . . . . . . 209
6.2.1 Some Asymptotics of ML estimators . . . . . . . . . . . . . . . 213
6.3 Numerical tips . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
6.4 ML estimation of DSGE models . . . . . . . . . . . . . . . . . . . . . . 218
6.5 Two examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
6.5.1 Does monetary policy react to technolocy shocks? . . . . . . 227
6.5.2 Does fiscal policy help to stabilize the cycle? . . . . . . . . . . 233

Chapter 7: Calibration 235

7.1 A Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
7.2 The Uncontroversial parts . . . . . . . . . . . . . . . . . . . . . . . . . . 237
7.3 Choosing parameters and stochastic processes . . . . . . . . . . . . . 239
7.4 Model Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246
7.4.1 Watson’s R2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
7.4.2 Measure of fit based on simulation variability . . . . . . . . . 253
7.4.3 Measures of fit based on sampling variability . . . . . . . . . 256
7.4.4 Measures of fit based on sampling and simulation variability 259
7.5 The sensitivity of the measurement . . . . . . . . . . . . . . . . . . . . 265
7.6 Savings, Investments and Tax cuts: an example . . . . . . . . . . . . 268
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Chapter 8: Dynamic Macro Panels 273

8.1 From economic theory to dynamic panels . . . . . . . . . . . . . . . . 274
8.2 Panels with Homogeneous dynamics . . . . . . . . . . . . . . . . . . . 276
8.2.1 Pitfalls of standard methods . . . . . . . . . . . . . . . . . . . . 278
8.2.2 The Correct approach . . . . . . . . . . . . . . . . . . . . . . . . 280
8.2.3 Restricted models . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
8.2.4 Recovering the individual effect . . . . . . . . . . . . . . . . . . 285
8.2.5 Some practical issues . . . . . . . . . . . . . . . . . . . . . . . . . 286
8.3 Dynamic heterogeneity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
8.3.1 Average time series estimator . . . . . . . . . . . . . . . . . . . 290
8.3.2 Pooled estimator . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
8.3.3 Aggregate time series estimator . . . . . . . . . . . . . . . . . . 294
8.3.4 Average Cross sectional Estimator . . . . . . . . . . . . . . . . 295
8.3.5 Testing for dynamic heterogeneity . . . . . . . . . . . . . . . . 297
8.4 To Pool or not to Pool? . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
8.4.1 What goes wrong with two-step regressions? . . . . . . . . . . 302
8.5 Is Money superneutral? . . . . . . . . . . . . . . . . . . . . . . . . . . . 304

Chapter 9: Introduction to Bayesian Methods 309

9.1 Preliminaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
9.1.1 Bayes Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
9.1.2 Prior Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
9.2 Decision Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
9.3 Inference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
9.3.1 Inference with Multiple Models . . . . . . . . . . . . . . . . . . 322
9.3.2 Normal Approximations . . . . . . . . . . . . . . . . . . . . . . . 323
9.3.3 Testing hypotheses/relative fit of different models . . . . . . 325
9.3.4 Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
9.4 Hierarchical and Empirical Bayes models . . . . . . . . . . . . . . . . 328
9.4.1 Empirical Bayes methods . . . . . . . . . . . . . . . . . . . . . . 332
9.4.2 Meta analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
9.5 Posterior simulators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
9.5.1 Normal posterior analysis . . . . . . . . . . . . . . . . . . . . . . 336
9.5.2 Basic Posterior Simulators . . . . . . . . . . . . . . . . . . . . . 337
9.5.3 Markov Chain Monte Carlo Methods . . . . . . . . . . . . . . 340
9.6 Robustness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
9.7 Estimating Returns to scale: Spain (1979-1999) . . . . . . . . . . . . 352

Chapter 10: Bayesian VARs 355

10.1 The Likelihood function of an m variable VAR(q) . . . . . . . . . . 356
10.2 Priors for VARs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
10.2.1 Least square under uncertain restrictions . . . . . . . . . . . . 358
10.2.2 The Minnesota prior . . . . . . . . . . . . . . . . . . . . . . . . . 359
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10.2.3 Adding other prior restrictions . . . . . . . . . . . . . . . . . . 363

10.2.4 Some Applied tips . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
10.2.5 Priors derived from DSGE models . . . . . . . . . . . . . . . . 366
10.2.6 Probability distributions for forecasts: Fan Charts . . . . . . 370
10.3 Structural BVARs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
10.4 Time Varying Coefficients BVARs . . . . . . . . . . . . . . . . . . . . 379
10.4.1 Minnesota style prior . . . . . . . . . . . . . . . . . . . . . . . . . 380
10.4.2 Hierarchical prior . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
10.5 Panel VAR models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384
10.5.1 Univariate dynamic panels . . . . . . . . . . . . . . . . . . . . . 385
10.5.2 Endogenous grouping . . . . . . . . . . . . . . . . . . . . . . . . . 388
10.5.3 Panel VARs with interdependencies . . . . . . . . . . . . . . . 392
10.5.4 Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395
10.5.5 Impulse responses . . . . . . . . . . . . . . . . . . . . . . . . . . . 396

Chapter 11: Bayesian time series and DSGE models 399

11.1 Factor Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
11.1.1 Arbitrage Pricing (APT) Models . . . . . . . . . . . . . . . . . 403
11.1.2 Conditional Capital Asset Pricing models (CAPM) . . . . . 406
11.2 Stochastic Volatility Models . . . . . . . . . . . . . . . . . . . . . . . . 408
11.3 Markov switching models . . . . . . . . . . . . . . . . . . . . . . . . . . 414
11.3.1 A more complicated structure . . . . . . . . . . . . . . . . . . . 415
11.3.2 A General Markov switching specification . . . . . . . . . . . 418
11.4 Bayesian DSGE Models . . . . . . . . . . . . . . . . . . . . . . . . . . . 420
11.4.1 Identification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
11.4.2 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 424
11.4.3 A few applied tips . . . . . . . . . . . . . . . . . . . . . . . . . . . 432
11.4.4 Comparing the quality of models to the data . . . . . . . . . 433
11.4.5 DSGEs and VARs, once again . . . . . . . . . . . . . . . . . . . 438
11.4.6 Non linear specifications . . . . . . . . . . . . . . . . . . . . . . . 439
11.4.7 Which approach to use? . . . . . . . . . . . . . . . . . . . . . . . 440

Appendix 443
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List of Figures

1.1 Short and long cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

1.2 Spectral Density . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
1.3 Filters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
1.4 Kernels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

3.1 Cyclical weights and gain function, HP filter . . . . . . . . . . . . . . . . . . 81

3.2 Gain functions, HP and ES filters . . . . . . . . . . . . . . . . . . . . . . . . 82
3.3 ACF of the cyclical component . . . . . . . . . . . . . . . . . . . . . . . . . 83
3.4 Gain: symmetric and asymmetric MA and HP filters . . . . . . . . . . . . . 89
3.5 Gain, ideal and approximate BP filters . . . . . . . . . . . . . . . . . . . . . 93
3.6 Monthly and Quarterly spectrum, simulated data and IP growth . . . . . . 99

4.1 Non fundamental technological progress . . . . . . . . . . . . . . . . . . . . 109

4.2 Bootstrap responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
4.3 Impulse responses to monetary shocks, Working capital model . . . . . . . . 141
4.4 Responses to a US policy shock, 1964:1-2001:10 . . . . . . . . . . . . . . . . 144
4.5 Quarterly and Monthly MA representations . . . . . . . . . . . . . . . . . . 145
4.6 Responses in the Blanchard and Quah model . . . . . . . . . . . . . . . . . 150
4.7 Responses to Monetary Shocks . . . . . . . . . . . . . . . . . . . . . . . . . 154

5.1 Responses to Monetary shocks in the model . . . . . . . . . . . . . . . . . . 198

5.2 Shape of distance function . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199

6.1 Likelihood function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223

6.2 Likelihood surface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
6.3 Impulse responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232

7.1 Watson’s measure of fit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252

7.2 Spectra and Coherences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
7.3 Distributions of Hours and Real Wage Correlation . . . . . . . . . . . . . . 260
7.4 Effects of tax cuts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272

8.1 Individual Effects, GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286

8.2 Cross sectional distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . 299

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8.3 Output growth responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

8.4 Alternative Estimators of Output Responses in Japan . . . . . . . . . . . . 306

9.1 Prior and posterior densities. . . . . . . . . . . . . . . . . . . . . . . . . . . 317

9.2 Highest credible set . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
9.3 Price Differential responses, US states . . . . . . . . . . . . . . . . . . . . . 335
9.4 Posterior simulators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
9.5 MCMC draws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
9.6 True and Gibbs sampling distributions . . . . . . . . . . . . . . . . . . . . . 346
9.7 MCMC simulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351

10.1 Minnesota prior. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361

10.2 Forecasts of Italian inflation. . . . . . . . . . . . . . . . . . . . . . . . . . . 372
10.3 Median and 68% band for the responses to a US monetary policy shock. . . 378
10.4 Median responses to US monetary policy shock. . . . . . . . . . . . . . . . . 385
10.5 Cross sectional density . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387
10.6 Convergence clubs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
10.7 One year ahead 68% prediction bands, EU . . . . . . . . . . . . . . . . . . . 398

11.1 Coincident Indicator. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404

11.2 Recession probabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416
11.3 Likelihood and Posterior, RBC model. . . . . . . . . . . . . . . . . . . . . . 424
11.4 Priors and Posteriors, Basic RBC. . . . . . . . . . . . . . . . . . . . . . . . 426
11.5 Priors and Posteriors, RBC with habit. . . . . . . . . . . . . . . . . . . . . . 427
11.6 CUMSUM statistic. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 429
11.7 Priors (dotted) and Posteriors (solid), Sticky price model. . . . . . . . . . . 431
11.8 Impulse Responses, sample 1948-2002. . . . . . . . . . . . . . . . . . . . . . 434
11.9 Impulse responses, various samples . . . . . . . . . . . . . . . . . . . . . . . 435
List of Tables

3.1 Simulated statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

3.2 Summary statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
3.3 US Business Cycle Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

4.1 Penalties of Akaike, Hannan and Quinn and Schwarz criteria . . . . . . . . 114
4.2 Lag length of a VAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.3 Regressions on simulated data . . . . . . . . . . . . . . . . . . . . . . . . . . 149

5.1 Estimates of New Keynesian Phillips curve . . . . . . . . . . . . . . . . . . 167

5.2 Estimates of a RBC model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
5.3 Moments of the data and of the model . . . . . . . . . . . . . . . . . . . . . 184
5.4 Indirect Inference Estimates of New Keynesian Phillips curve . . . . . . . . 195

6.1 ML estimates, Sticky Price model . . . . . . . . . . . . . . . . . . . . . . . . 229

6.2 Cross covariances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
6.3 ML estimates, US 1948-1984 . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
6.4 Diebold and Mariano Statistic . . . . . . . . . . . . . . . . . . . . . . . . . . 234

7.1 Monte Carlo distribution of α|ρ . . . . . . . . . . . . . . . . . . . . . . . . . 244

7.2 ACF of hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
7.3 Cross correlation hours-wage . . . . . . . . . . . . . . . . . . . . . . . . . . 255
7.4 Parameters selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
7.5 The Fit of the Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270

8.1 Growth and Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277

8.2 Bias in the AR(1) coefficient . . . . . . . . . . . . . . . . . . . . . . . . . . 279
8.3 Monte Carlo evidence I . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
8.4 Monte Carlo evidence II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288

9.1 Posterior distribution of returns to scale . . . . . . . . . . . . . . . . . . . . 354

10.1 One year ahead Theil-U statistics. . . . . . . . . . . . . . . . . . . . . . . . 366

10.2 Marginal Likelihood, Sticky price sticky wage model. . . . . . . . . . . . . . 370

ix
x

11.1 Percentiles of the approximating distributions . . . . . . . . . . . . . . . . . 409

11.2 Variances and Covariances . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426

11.3 Prior and posterior statistics. . . . . . . . . . . . . . . . . . . . . . . . . . . 430

 i

Preface
There has been a tremendous improvement over the last twenty years in the mathemati-
cal, statistical, probabilistic and computational tools available to applied macroeconomists.
This extended set of tools has changed the way researchers have approached the problem of
testing models, validate theories or simply collect regularities from the data. The rational
expectation and the calibration revolutions have also forced researchers to try to build a
more solid bridge between theoretical and applied work, a bridge which was often missing
in much of the applied exercises conducted in the 1970s and the 1980s.
This books attempts to bring together dynamic general equilibrium theory, data analy-
sis, advanced econometric and computational methods to provide a comprehensive set of
techniques which can be used to address questions of interest to academics, business and
central bank economists in the fields of macroeconomics, business cycle analysis, growth
theory, monetary, financial, and international economics. The point of view taken is the
one of an applied economist facing time series data (at times a panel of them, coming from
different countries), who is interested in verifying the prediction of dynamic economic theo-
ries and in advising model builders and theorists on how to respecify existing constructions
to obtain better match between the model and the data. The book illustrates a number
of techniques which can be used to address the questions of interest, agnostically evalu-
ates their usefulness in bringing out information relevant to the users, provides examples
where the methods work (and where they don’t) and points out problems when approaches
developed for microeconomic data are used in time series frameworks.
Unavoidably, a modern treatment of such a complex topic requires a quantitative per-
spective, a solid dynamic theory background and the development of both empirical and
numerical methods. A quantitative perspective is needed to give empirical content to the-
ories; empirical methods must provide an effective link between economic theory and the
data; numerical techniques help us to solve complicated dynamic stochastic general equi-
librium (DSGE) models and to implement advanced econometric estimators, both in the
classical and Bayesian tradition. In some cases empirical methods are intimately linked with
the numerical procedure chosen to solve the model. In others, they are only constrained by
the restrictions economic theory imposes on the data.
Given this background, the structure of this book is quite different from the typical
graduate textbook both in macroeconomics and in econometrics. Rather than listing a series
of estimators and their properties for different data generating processes, this book starts
from a class of DSGE models, finds an approximate (linear) representation for the decision
rules and describes methods needed to estimate/choose their parameters, to examine their
fit to the data and to conduct interesting policy exercises. The first three chapters of the
book are introductory and review material extensively used in later chapters. In particular,
chapter 1 presents basic time series and probability concepts, a list of useful law of large
numbers and central limit theorems, which are employed in the discussions of chapters 4
to 8, and gives a brief overview of the basic elements of spectral analysis, heavily used
in chapters 3, 5 and 7. Chapter 2 presents a number of macroeconomic models currently
ii

used in the profession and discusses numerical methods needed to solve them. Most of
the examples and exercises of this book are based on versions of these models. Chapter
3 discusses procedures used to obtain interesting information about secular and cyclical
fluctuations in the data.
In the remaining chapters we present various methodologies to confront models to the
data and discuss how they can be used to address other interesting economic questions.
Given our empirical perspective, formal results are often stated without proofs and em-
phasis is given to their use in particular macroeconomic applications. Chapter 4 describes
minimalist vector autoregressive (VAR) approaches, where a limited amount of economic
theory is used to structure the data. Chapter 5 presents limited information methodologies
such as Generalized Methods of Moments (GMM), Simulated Method of Moments (SMM)
and general simulation approaches. Chapter 6 examines full information Maximum Likeli-
hood and in chapter 7 Calibration techniques are discussed. In chapter 8, we then branch
into dynamic macro panel methods, which can be used to effectively study cross-country
issues, and conclude the book with an extensive description of Bayesian methods and their
use for VAR and panel VAR models, for advanced time series specifications, and for DSGE
models (Chapters 9 to 11).
The approach of this book differs, for example, from the one of Hamilton (1994) or
Hayashi (2002), both of which are primarily directed to econometricians and are not directly
concerned with the question of validating dynamic economic models. The emphasis also
differs from more macroeconomic oriented books like Sargent and Liungqvist (2001) or
computationally oriented books like Judd (1998) or Miranda and Fackler (2002) in that
empirical methods play a larger role and the connection between theory, numerical and
empirical tools is explicitely spelled out.
The book is largely self-contained but presumes a basic knowledge of modern macroeco-
nomic theory (say, one or two quarters of a Ph.D. course in macroeconomics), of standard
econometrics (say, a quarter of a Ph. D. course in econometrics) and assumes that the reader
has or will acquire in the process some programming skills (e.g., RATS, Matlab, Gauss).
The book is thought for a year long sequence starting from second semester of a first year
econometric/ applied macroeconomics course and continuing with the first semester of a
second year macroeconometric course. Roughly, the first 5 chapters and the seventh could
be thought in first part, chapter 6 and the last four in the second part. This is the setup I
have used in teaching this material over a number years and it seems the natural division
between what I consider basic and advanced material.
Ph. D. students at Brown University, University of Rochester, Universitat Pompeu
Fabra, Universita’ di Napoli, University of Porto, University of Southampton, London Busi-
ness School, Bocconi University, Universita’ Milano-Bicocca; participants in various editions
of the Barcelona Summer School in Macroeconomics (BSSM), of the European Economic
Association (EEA) Summer school in Macroeconomics, Paris, of the Center for Financial
Studies (CFS) Summer school in Macroeconomics, Eltville (Germany), of the ZEI Summer
School in Bonn, of the course for Central Bankers in Genzersee (Switzerland); and atten-
dants of various intense and short courses at the ECB, Bank of England, Bank of Italy,
 iii

Bank of Canada, Bank of Hungary, Riksbank, Bundesbank and European Business Cycle
Network (EABCN) have passed through several versions of this book and played around
with some of the codes which implement the procedures discussed in the book with some
practical examples. Some suffered; some enthusiastically embraced the philosophy of this
book; some were critical; some made useful comments and helped in debugging the codes,
all of them were encouraging. To all goes my thanks. I have learned a lot through the
process of writing this book and teaching its material, probably as much as students have
learned from the lectures and practical sessions.
Three people taught me to approach empirical problems in a sensible but rigorous way,
combining economic theory with advanced statistical tools and numerical methods, and to
be suspicious and critical of analyses which leave out one of the main ingredients of the cake.
Christopher Sims and Tom Sargent where of crucial importance in making me understand
that the grey area at the crossroad between theory and econometrics is a difficult but
exciting place to be and their uncompromising intellectual curiosity, their stern intuition
and their deep understanding of economic and policy issues has been an extraordinary
lever behind this book. Adrian Pagan shaped my (somewhat cynical) view of what should
and can be done with the data and the models. I always like to argue with him because
his unconventional views helped to bring out often forgotten methodological and practical
aspects. And on most issues of interest to applied macroeconomists he was more often
right than wrong. This book would not have been possible without their fundamental
inputs. As mentors, there was no one comparable to them. I also have an intellectual debit
with Ed Prescott. It was his brusc refusal to follow the traditional econometric track that
made me understand the need to create a different and more solid link between theory,
econometric and statistical techniques and the data. Several of my collegues, in particular
Albert Marcet and Morten Ravn, Jordi Gali, Lucrezia Reichlin, Harald Uhlig, Carlo Favero,
Marco Maffezzoli and Luca sala contributed to form and develop some of the ideas presented
in the book. A special thanks goes to Tom Doan, Marco del Negro, Chris Sims, Kirdan
Lees and Adrian Pagan, who spotted mistakes and imprecisions in earlier versions of the
manuscript.
Writing a textbook is difficult. Writing an advanced textbook, which bring together
material from different fields, is even more formidable. Many times I run out of steam,
I got bored and was ready to give up and do something different. Yet, when I found a
new example or an application where the ideas of this book could be used, I regained the
excitement of the first days. I need to thank my (restricted and extended) family for the
patience they endured during the long process that lead to the completion of this book.
Dynamic macroeconomics is in part about intertemporal substitution. Patience is probably
built on the same principle.