Forecasting with a DSGE Model of a Small Open Economy within the Monetary Union

Forecasting with a DSGE Model of a Small Open Economy within the Monetary Union

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Article ID: iaor201523633
Volume: 33
Issue: 5
Start Page Number: 315
End Page Number: 338
Publication Date: Aug 2014
Journal: Journal of Forecasting
Authors: ,
Keywords: finance & banking, forecasting: applications, stochastic processes
Abstract:

In this paper we lay out a two‐region dynamic stochastic general equilibrium (DSGE) model of an open economy within the European Monetary Union. The model, which is built in the New Keynesian tradition, contains real and nominal rigidities such as habit formation in consumption, price and wage stickiness as well as rich stochastic structure. The framework also incorporates the theory of unemployment, small open economy aspects and a nominal interest rate that is set exogenously by the area‐wide monetary authority. As an illustration, the model is estimated on Luxembourgish data. We evaluate the properties of the estimated model and assess its forecasting performance relative to reduced‐form model such as vector autoregression (VAR). In addition, we study the empirical validity of the DSGE model restrictions by applying a DSGE‐VAR approach.

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