Validating DSGE Models Through Dynamic Factor Models

Abstract

We urge the use of Structural Dynamic Factor Models (DFM) to validate and to guide the construction of Dynamic Stochastic General Equilibrium (DSGE) models. The main reason is that the log-linear solution of a DSGE model has a factor structure which ensures consistency between the representations of the two models. We assess, by means of a few simulations, the validity of SDFM as an empirical tool to complement DSGE analysis. Using a DSGE model as data generating process, the factor model provides very accurate estimates of the true impulse response functions. As an application, we validate a theory of TFP news and surprise shocks.