Constructing and Estimating a Realistic Optimizing Model of Monetary Policy

A dynamic stochastic general-equilibrium (DSGE) model with real and nominal, both price and wage, rigidities succeeds in capturing some key nominal features of U.S. business cycles. Additive technology shocks, as well as multiplicative shocks, are introduced and shown to be crucial. Monetary policy is specified as an interest rate targeting rule following developments in the structural vector autoregression (VAR) literature. The interaction between real and nominal rigidities is essential to reproduce the liquidity effect of monetary policy. The model is estimated by maximum likelihood on U.S. data, and its fit is comparable to that of an unrestricted first-order VAR. Besides producing reasonable impulse responses and second moments, this model replicates a feature of U.S. business cycles, never captured by previous research with DSGE models, that an increase in interest rates predicts a decrease in output two to six quarters in the future