Taking Trends Seriously in DSGE Models: An Application to the Dutch Economy

Abstract

We construct a new-Keynesian DSGE model tailored to the Netherlands and interpret it as a multivariate unobserved components model. We identify three major stochastic trends in the data — trends in general - purpose technology, investment-specific technology, and labor supply — and model them formally in our theoretical set-up. Our trend-cycle decomposition captures the data’s co-integrating properties without which long-run analysis — whether scenario analysis or forecasting — would likely be mis-specified. In particular, this approach appears to produce better-behaved posteriors for parameters along decision margins where traditional modeling imposes highly persistent but temporary shocks. The existence of permanent and temporary disturbances along the same margin broadens the scope for counter-factuals. Specifically, differences in short-run responses to the two types of shocks reflect smoothing motives and discounted valuation effects reminiscent of the Permanent Income Hypothesis.

JEL Classification: C54, E27, E37, E47