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

• Author: Massimiliano Marcellino,Yuliya Rychalovska
• DOI: http://doi.org/10.1002/for.2306
• Date: 01 August 2014
• Published date: 01 August 2014

Journal of Forecasting,J. Forecast. 33, 315–338 (2014)

Published online in Wiley Online Library (wileyonlinelibrary.com) DOI: 10.1002/for.2306

Forecasting with a DSGE Model of a Small Open Economy

within the Monetary Union

MASSIMILIANO MARCELLINO1;2AND YULIYA RYCHALOVSKA3,4

1

IGIER, Bocconi University, Milan Italy

2

CEPR, London, UK

3

STATEC, Luxembourg

4

CERGE-EI, Prague, Czech Republic

ABSTRACT

In this paper we lay out a two-region dynamic stochastic general equilibrium (DSGE) model of an open econ-

omy 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. Copyright © 2014 John

Wiley & Sons, Ltd.

KEY WORDS DSGE models; DSGE-VAR; open economy; forecasting; VAR

INTRODUCTION

In recent decades a new approach to macroeconomic modeling has involved the development of a generation

of real business cycle models (the New Keynesian or New Neoclassical Synthesis models), which propose to

extend the general equilibrium framework by introducing imperfect competition and nominal rigidities. An impor-

tant feature of this class of models—often referred to as dynamic stochastic general equilibrium (DSGE)—is that

monetary policy has a non-trivial effect on real variables. Therefore, studying the business cycle and macroeco-

nomic implications of alternative government policies has been a natural application of this new generation of

models and has motivated much research. Earlier contributions, including those which extend the framework to open

economies, are Clarida et al. (1999, 2001), Benigno and Benigno (2003), Gali and Monacelli (2005) and many others.

Recent developments in numerical and estimation methods enabled the application of advanced econometrics

techniques to test the properties of the new generation of DSGE models, which showed better performance in

capturing observed characteristics of real data due to stronger internal persistence mechanisms. Therefore, there is

a growing interest from both academia and policy-making institutions in further advancing and using these models

for studying macroeconomic fluctuations, assessing economic policy and forecasting. The most influential empirical

papers in this area include Smets and Wouters (2003, 2007), who estimate a DSGE model similar in spirit to

Christiano et al. (2005) for the euro area and USA respectively. The authors demonstrate that the estimated model

provides a reasonable description of the economy and thus can serve as a useful tool for analysis of the effects of

monetary policy and other structural shocks. Another important conclusion is that the forecasting performance of the

DSGE model compares well with reduced-form structures such as vector autoregression (VAR) and Bayesian vector

autoregression (BVAR) models. Following this seminal work, much research has been done to exploit DSGE mod-

eling to study the macroeconomic fluctuations in various countries. In particular, Adolfson et al. (2008) examine

the properties of a small open-economy model with modified uncovered interest parity (UIP) condition estimated on

Swedish data. Lees et al. (2007) evaluate the performance of a small-scale DSGE model applied to New Zealand

data. Lubik and Schorfheide (2007) estimate a small-scale DSGE model of a small open economy with a focus

on the comparison of the monetary policy conduct in Australia, Canada, New Zealand and the UK. A number of

studies employ a two-country framework to analyze the business cycleof European economies within the euro area. In

particular, Pytlarczyk (2005) presents a DSGE model for Germany within the monetary union. Burriel et al. (2010)

develop a DSGE model for the Spanish economy. There are also similar studies for Austria (Breuss and Rabitsch,

2009), France (Jondeau and Sahuc, 2004) and other countries.

Correspondence to: Massimiliano Marcellino, IGIER, Bocconi University,20136 Milan, Italy. E-mail: massimiliano.marcellino@unibocconi.it

Copyright © 2014 John Wiley & Sons, Ltd

316 M. Marcellino and Y. Rychalovska

This paper contributes to the fast-growing DSGE literature described above and presents a model of a small open

economy within the European Monetary Union, combining several of the features in the papers mentioned above.

In particular, we develop a medium-scale two-region structural model with monopolistic competition in goods and

labor markets. The model contains a number of frictions such as habit formation in consumption and price and

wage rigidities, which became fairly standard in the recent literature. We adopt a small open economy setup that

implies that the rest of the world (euro area) is not affected by domestic dynamics. As a result, the central bank

policy instrument—the nominal interest rate—is exogenous from the home economy perspective. We derive a small

open economy representation as a limiting case of a two-country framework and, unlike many of the recent DSGE

papers, consider a medium- rather than small-scale specification with an explicit modeling of the labor markets and

unemployment. In this respect, we follow an original paper by Gali et al. (2012; GSW hereafter) that incorporates

unemployment into the Smets and Wouters (2007) closed-economy model.

From the empirical side, we contribute to the recent DSGE literature by presenting evidence for an additional

country on the fit and forecasting performance of DSGE models estimated with a Bayesian approach. More specifi-

cally, we analyze the main properties of the estimated model, assessing the importance of variousshocks and frictions

for explaining the dynamics of the Luxembourgish economy.1

We then evaluate the model’s point and density forecasting performance by comparing the accuracy of its

out-of-sample predictions relative to those from reduced-form models such as VARs. In addition, we study the

empirical validity of DSGE model restrictions by applying a DSGE-VAR analysis, as developed by Del Negro and

Schorfheide (2004) and Del Negro et al. (2005). Weinclude the DSGE-VAR model in the forecasting exercise in order

to assess the ability of the DSGE-based versus atheoretical (BVAR) prior to improve the forecasting performance of

the unrestricted VAR model.2

In the process of description of the estimation results we discuss how our work compares to previous studies. Our

DSGE model shows a superior out-of-sample forecasting performance (at the 1-quarter-ahead horizon) compared to

unrestricted VARs and BVARs. We also demonstrate that the restrictions implied by the DSGE model lead to an

improvement of the performance of the standard VAR in predicting dynamics of the labor market variables such as

wages and unemployment.

The paper is organized as follows. In the next two sections we present our small open-economy model and its

log-linear representation. The fourth section describes the data, alternative forecasting models and estimation results.

The forecast evaluation and comparison are presented in the fifth section. Finally, the sixth section contains some

concluding remarks.

A SMALL OPEN-ECONOMY MODEL

In this section we formulate an open-economy DSGE model with theoretical foundations closely related to the papers

by Gali and Monacelli (2005) and De Paoli (2009).3The model contains a number of rigidities typically used in the

empirical DSGE literature in order to capture the properties of real data (Christiano et al., 2005; Smets and Wouters,

2003, 2007). In particular, we introduce habit formation in consumption as well as Calvo price and wage stickiness.

Moreover, we explicitly incorporate the theory of unemployment into the model setup following the recent paper

by GSW.

The framework is represented by a two-country dynamic general equilibrium model where both sides, Home

(the small open economy: H) and Foreign (the rest of the world, the relatively closed economy: F), are explicitly

modeled. A continuum of infinitively lived domestic households belongs to the interval Œ0;n/, while foreign agents

belong to the segment .n; 1: The small open-economy problem is derived as a limiting case .n !0/ of such a

framework (as in De Paoli, 2009). Therefore, the home economy, owing to its small size, is assumed to have a

negligible impact on the rest of the world. Households receive utility from consumption and disutility from work. The

home economy is composed of final and intermediate goods producers, consumers and labor unions.4Agents consume

1As for existing structural models for Luxembourg, Pierrard and Sneessens (2009) havedeveloped an overlapping generations (OLG) small open-

economy model. The authors concentrate on modeling the realistic features of the Luxembourg labor market. The ‘pure’ OLG representation

allows study of demographic questions such as the consequences of the aging of the population and the potential effects of alternative macroeco-

nomic policies. The model is then calibrated on Luxembourg data and simulated. Other studies for Luxembourg based on the DSGE methodology

include papers by Deak et al. (2011, 2012). These papers present an LSM—DSGE small open-economy model for Luxembourg—which is built

following Blanchard’s (1985) OLG approach. The model incorporates more realistic goods market structure with monopolistic competition, the

distinction between tradable, non-tradable goods and the banking sector. The model is calibrated and used to study the reaction of the economy

to real and financial shocks.

2The working paper version of this work, Marcellino and Rychalovska (2012), also contains the analysis of contribution of structural shocks to

business cycle fluctuations. In particular, we use the estimated model to calculate variance decompositions and impulse responses, in order to

evaluate the sources and propagation of macroeconomic fluctuations.

3We focus on the main model equations relevant for the open-economy specification. The rest of the model is rather standard. More detailed

derivation of the structural equations can be found in Marcellino and Rychalovska (2012).

4We assume a somewhat simplified structure for the foreign economy. In particular, we abstract from explicit modeling the production side and

assume that households are both consumers and producers. Moreover, we assume that there are no labor market frictions and unemployment.

Copyright © 2014 John Wiley & Sons, Ltd J. Forecast. 33, 315–338 (2014)