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Implementing Stochastic Volatility in DSGE Models: A Comment

21 Pages Posted: 21 Oct 2017 Last revised: 3 Nov 2017

Lorenzo Bretscher

London School of Economics & Political Science (LSE)

Alex C. Hsu

Georgia Institute of Technology - Scheller College of Business

Andrea Tamoni

London School of Economics & Political Science (LSE)

Date Written: October 20, 2017

Abstract

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, it is not correct in general when the magnitude of SV is large. Not correcting for this potential 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

Bretscher, Lorenzo and Hsu, Alex C. and Tamoni, Andrea, Implementing Stochastic Volatility in DSGE Models: A Comment (October 20, 2017). Georgia Tech Scheller College of Business Research Paper No. 17-40. Available at SSRN: https://ssrn.com/abstract=3056250

Lorenzo Bretscher

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Alex Hsu

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States
4043851123 (Phone)

Andrea Tamoni (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom
02079557303 (Phone)

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