An estimated DSGE model of a Small Open Economy within the Monetary Union: Forecasting and Structural Analysis

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