Bayesian estimation of a dynamic stochastic general equilibrium model with asset prices

This paper presents a novel Bayesian method for estimating dynamic stochastic general equilibrium (DSGE) models subject to a constrained posterior distribution for the implied Sharpe ratio. We apply our methodology to a DSGE model with habit formation in consumption and leisure, and show that the constrained estimation produces both reasonable assetpricing and business-cycle implications. Next, we estimate the Smets-Wouters model subject to the same Sharpe ratio constraint. The results move the model closer to reproducing observed risk premia, but at increasing cost to its macroeconomic performance.