Rare shocks, Great Recessions

By Vasco Cúrdia, Marco Del Negro and Daniel Greenwald

http://d.repec.org/n?u=RePEc:fip:fedfwp:2013-01&r=dge

We estimate a DSGE model where rare large shocks can occur, by replacing the commonly used Gaussian assumption with a Student-t distribution. Results from the Smets and Wouters (2007) model estimated on the usual set of macroeconomic time series over the 1964-2011 period indicate that the Student-t specification is strongly favored by the data even when we allow for low-frequency variation in the volatility of the shocks, and that the estimated degrees of freedom are quite low for several shocks that drive U.S. business cycles, implying an important role for rare large shocks. This result holds even if we exclude the Great Recession period from the sample. We also show that inference about low-frequency changes in volatility and in particular, inference about the magnitude of the Great Moderation is different once we allow for fat tails.

This paper shows that rare events matter, and so even if they do not appear in the data. This means a rejection of the common assumption that shocks are normally distributed. That, we knew already, one has simply to observe that recessions are shorter and steeper than booms. The merit of the paper is to show that the simplifying assumption of normally distributed shocks matters in modelling. What this means in terms of policy remains to be seen.

About these ads

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Follow

Get every new post delivered to your Inbox.

Join 335 other followers

%d bloggers like this: