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1 results

  • IMPLEMENTING STOCHASTIC VOLATILITY IN DSGE MODELS: A COMMENT

  • Lorenzo Bretscher, Alex Hsu, Andrea Tamoni
  • Journal:
    Macroeconomic Dynamics / Volume 24 / Issue 4 / June 2020
    Published online by Cambridge University Press:
    29 November 2018, pp. 935-950

  • We highlight a state variable misspecification with one accepted method to implement stochastic volatility (SV) in DSGE models when transforming the nonlinear state-innovation dynamics to its linear representation. Although the technique is more efficient numerically, we show that it is not exact but only serves as an approximation when the magnitude of SV is small. Not accounting for this approximation error may induce substantial spurious volatility in macroeconomic series, which could lead to incorrect inference about the performance of the model. We also show that, by simply lagging and expanding the state vector, one can obtain the correct state-space specification. Finally, we validate our augmented implementation approach against an established alternative through numerical simulation.