An Estimated DSGE Model of a Small Open Economy within the Monetary Union: Forecasting and structural analysis

Abstract

In this paper we lay out a two-region DSGE model of an open economy within the European Monetary Union. The model, which is built in the New Keynesian tradition, contains real and nominal rigidities such as habit formation in consumption, price and wage stickiness as well as rich stochastic structure. The framework also incorporates the theory of unemployment as in Gali et al. (2011), small open economy aspects and a nominal interest rate that is set exogenously by the area-wide monetary authority. As an illustration, the model is estimated on Luxembourgish data. We evaluate the properties of the estimated model and assess its forecasting performance relative to reduced form models such as VARs. In addition, we study the empirical validity of the DSGE model restrictions by applying a DSGE-VAR approach. Finally, the estimated model is used to analyze the sources of macroeconomic fluctuations and examine the responses of the economy to structural shocks.