An Estimated DSGE Model for the United Kingdom

By DiCecio, Riccardo; Nelson, Edward | Federal Reserve Bank of St. Louis Review, July-August 2007 | Go to article overview
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An Estimated DSGE Model for the United Kingdom


DiCecio, Riccardo, Nelson, Edward, Federal Reserve Bank of St. Louis Review


The authors estimate the dynamic stochastic general equilibrium model of Christiano, Eichenbaum, and Evans (2005) on U.K. data. Their estimates suggest that price stickiness is a more important source of nominal rigidity in the United Kingdom than wage stickiness. Their estimates of parameters governing investment behavior are only well behaved when post-1979 observations are included, which reflects government policies until the late 1970s that obstructed the influence of market forces on investment. (JEL E31, E32, E52)

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In this paper we estimate a dynamic stochastic general equilibrium (DSGE) model with nominal rigidities for the U.K. economy. The model we estimate is due to Christiano, Eichenbaum, and Evans (2005; CEE) and has become a benchmark, matching important aspects of the U.S. data while also being derived from optimizing behavior.

Interest in DSGE modeling of the United Kingdom has been heightened in recent years with the introduction of the Bank of England quarterly model (BEQM) into the U.K. monetary policy process. This model is based to a considerable degree on explicit optimizing foundations; see Harrison et al. (2005) for the model and Pagan (2005) for a discussion. BEQM is, however, dissimilar in important respects from the CEE model of the United States and the variant of the CEE model that Smets and Wouters (2003) estimate for the euro area. These dissimilarities make it difficult to use BEQM to compare the structure of the U.K. economy with that of other economies. For example, the estimation procedure for BEQM is different from that used by CEE and by Smets and Wouters; portions of the BEQM model are estimated over a considerably shorter sample than CEE consider for the United States, and there are deviations from explicit optimization in the dynamics of the BEQM model.

All in all, it is probably fair to say that there has been considerably less work done for the United Kingdom in terms of DSGE modeling with systems estimation than there has been for other economies. But U.K. data may contain a type of information that is ideal for estimation of a DSGE model--specifically, information on private sector responses to policy actions. As the present governor of the Bank of England, Mervyn King, observed some 30 years ago,

   Maintenance of the existing order and existing rates produces no
   information, whereas more information can be obtained by making
   changes. In this respect the U.S.... is at a disadvantage by
   comparison with the U.K. A good illustration of this is afforded by
   the excitement generated amongst American economists in the 1960s
   by the investment tax credit and the attempts to assess its
   effects. A British economist would have shrugged this off as a
   mere trifle compared to the changes he had witnessed over the
   years. (King, 1977, p. 6)

This observation, though made with reference to the changes wrought in U.K. fiscal policy up to the 1960s, applies tenfold to monetary policy experience in the period since the 1960s. Over that period, the United Kingdom has undergone great variation in inflation, interest rates, and monetary regimes. (1) It is true that for estimation this is a mixed blessing because large regime changes make it problematic to estimate a structural model over a long sample. But Christiano, Eichenbaum, and Evans (1999) and Sims and Zha (2006) argue for the United States that constant-parameter policy reaction functions may be reasonable approximations even over long samples, a view also implicit in CEE's (2005) choice of a 1965-95 estimation period. In modeling the United Kingdom using a DSGE model, we make a compromise between these positions by treating the period since 1979 as a single regime, (2) but also by presenting results for pre-1979 and a long sample covering 1962-2005. (3)

We present in the following sections our model, estimates for our main sample, and results for the longer sample, with a discussion of other regime-change issues.

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