Bayesian Estimation of the DSGE Model of the Euro Area: Imperfect Knowledge

The recent tendency of implementing the advanced techniques for systematic policy analysis has encouraged a large literature on building and estimation of DSGE models. However, important challenges in the modeling approach have to be highlighted. Standard macro models with rational expectations tend to miss the observed persistence of the key economic time series such as inflation and output gap. The extensions of a standard framework suggest complementing a micro-founded stylized model with a number of frictions that enable capturing the dynamic properties of real data. At the same time, various assumptions about the potential source of persistence can result in a different dynamics of the model variables. For example, the introducing of imperfect exchange rate path-through determines the degree of the exchange rate flexibility. Similarly, the inclusion of “mechanical ” endogenous persistence mechanism, such as habit formation and price indexation, can considerably change the performance of the model. Nowadays, the empirical literature attempts to evaluate the ability of the various DSGE models to fit macroeconomic data. Such an analysis of DSGE models is important in order to assess the validity of alternative modeling assumptions and it gains further relevance when considering the growing interest to the application of micro-founded DSGE models for policy making in Centra