Implementing Stochastic Volatility in DSGE Models: A Comment
22 Pages Posted: 21 Oct 2017 Last revised: 1 Jul 2018
Date Written: December 17, 2017
We highlight a state variable misspecification with one accepted method to implement stochastic volatility (SV) in DSGE models when transforming the nonlinear state-innovation dynamics to its linear representation. Although the technique is more efficient numerically, we show that it is not exact but only serves as an approximation when the magnitude of SV is small. Not accounting for this approximation error may induce substantial spurious volatility in macroeconomic series, which could lead to incorrect inference about the performance of the model. We also show that, by simply lagging and expanding the state vector, one can obtain the correct state-space specification. Finally, we validate our augmented implementation approach against an established alternative through numerical simulation.
Keywords: Dynamic equilibrium economies, Stochastic volatility, Perturbation, Matlab code
JEL Classification: C63, C68, E37
Suggested Citation: Suggested Citation