Balanced Growth Approach to Tracking Recessions

Abstract

In this paper, we propose a hybrid version of Dynamic Stochastic General Equilibrium models with an emphasis on parameter invariance and tracking performance at times of rapid changes (recessions). We interpret hypothetical balanced growth ratios as moving targets for economic agents that rely upon an Error Correction Mechanism to adjust to changes in target ratios driven by an underlying state Vector AutoRegressive process. Our proposal is illustrated by an application to a pilot Real Business Cycle model for the US economy from 1948 to 2019. An extensive recursive validation exercise over the last 35 years, covering 3 recessions, is used to highlight its parameters invariance, tracking and 1- to 3-step ahead forecasting performance, outperforming those of an unconstrained benchmark Vector AutoRegressive model.

On DSGE Models

“…In this state of the world, agency problems associated with asymmetric information become important. 6 As part of the specification of the model, Gertler and Kiyotaki (2015) assume that the probability of a rollover crisis is proportional to the losses that depositors would experience in the event that a rollover crisis occurs. Thus, if bank creditors think that banks' net worth would be positive in a crisis, then a rollover crisis is impossible.…”

“…The key theoretical antecedent is the bank run model ofDiamond and Dybvig (1983) and the sovereign debt rollover crisis model ofCole and Kehoe (2000) 5. Unlike in the classic bank run model ofDiamond and Dybvig (1983), there is no reason to impose a sequential debt service constraint 6. Gertler and Kiyotaki (2015) capture these agency problems by assuming that the buyers of long-term assets during a rollover crisis are relatively inefficient at managing the assets.…”