An estimated DSGE model of a Small Open Economy within the Monetary Union: Forecasting and Structural Analysis

In this paper we build and estimate a two-region DSGE model of a small open economy within the European Monetary Union. We evaluate the properties of the estimated model and assess its forecasting performance (point and density) relative to reduced form models such as VARs. In addition, we study the empirical validity of the DSGE model restrictions (based on micro-foundations) by applying a DSGE-VAR approach. Finally, the estimated model is used to analyze the sources of macroeconomic fluctuations and examine the We allow for a sufficiently rich specification which enables us to include unemployment as well as open economy variables such as the real exchange rate into the estimation procedure, along with the standard macroeconomic and labor market indicators. The model contains a set of frictions and structural shocks typically used in the DSGE literature. We evaluate the properties of the estimated model and assess its forecasting performance relative to reduced form models such as VARs. In addition, we study the empirical validity of the DSGE model restrictions by applying a DSGE-VAR approach. Finally, the estimated model is used to analyze the sources of macroeconomic fluctuations and examine the responses of the economy to structural shocks. The model is built in the New Keynesian tradition and 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 as in Gali et al. (2011), small open economy aspects and a nominal interest rate that is set exogenously by the area-wide monetary authority. The model is estimated using Bayesian techniques. We demonstrate that the estimated DSGE model is relatively well identified, has good data fit and reasonably estimated parameters. In addition, the model shows a competitive forecasting performance (in terms of both point and density) compared to reduced form models such as VARs. In this respect, our results are in line with the conclusions reached in previous studies that the new generation of DSGE models no longer faces the tension between rigor and fit. In particular, we illustrate that the DSGE model produces sizable one-step-ahead forecasting gains in terms of RMSE and the Score over the unrestricted VAR, especially for such variables as GDP, real exchange rate, unemployment and real wages. The predictions stay competitive at longer forecasting horizons. DSGE-VAR analysis demonstrates that the optimal weight on the DSGE restrictions is significant and the VAR(2) correction is not helpful in improving the DSGE model fit. At the same time, the DSGE-based prior significantly improves the short term forecast accuracy of the unrestricted VAR for output, and also determines a superior performance of the DSGE-VAR model in predicting exchange rate, unemployment and wages over all the forecast horizons considered here. When compared to an atheoretical Minnesota-style prior, the DSGE restrictions appear to be more useful in forecasting output and REER, whereas the opposite is true for employment. Application of the model to the analysis of the business cycle fluctuations demonstrates that "open economy" disturbances such as relative price, foreign demand and interest rate shocks explain a significant portion of the variation of output growth, inflation, real exchange rate and employment. Price and wage markup shocks are important determinants of inflation and real wages dynamics respectively.