Ensuring the Validity of the Micro Foundation in DSGE Models
CREATES Research Paper 2008-26
45 Pages Posted: 25 Jun 2008
Date Written: May 26, 2008
The presence of i) stochastic trends, ii) deterministic trends, and/or iii) stochastic volatility in DSGE models may imply that the agents' objective functions attain infinite values. We say that such models do not have a valid micro foundation. The paper derives sufficient conditions which ensure that the objective functions of the households and the firms are finite even when various trends and stochastic volatility are included in a standard DSGE model. Based on these conditions we test the validity of the micro foundation in six DSGE models from the literature. The models of Justiniano & Primiceri (American Economic Review, forthcoming) and Fernández-Villaverde & Rubio-Ramírez (Review of Economic Studies, 2007) do not satisfy these sufficient conditions, or any other known set of conditions ensuring finite values for the objective functions. Thus, the validity of the micro foundation in these models remains to be established.
Keywords: Deterministic trends, DSGE models, Error distributions, Moment generating functions, Stochastic trends, Stochastic volatility, Unit-roots
JEL Classification: E10, E30
Suggested Citation: Suggested Citation