Data-Rich DSGE and Dynamic Factor Models

Dynamic factor models and dynamic stochastic general equilibrium (DSGE) models are widely used for empirical research in macroeconomics. The empirical factor literature argues that the co-movement of large panels of macroeconomic and financial data can be captured by relatively few common unobserved factors. Similarly, the dynamics in DSGE models are often governed by a handful of state variables and exogenous processes such as preference and/or technology shocks. Boivin and Giannoni(2006) combine a DSGE and a factor model into a data-rich DSGE model, in which DSGE states are factors and factor dynamics are subject to DSGE model implied restrictions. We compare a data-richDSGE model with a standard New Keynesian core to an empirical dynamic factor model by estimating both on a rich panel of U.S. macroeconomic and financial data compiled by Stock and Watson (2008).We find that the spaces spanned by the empirical factors and by the data-rich DSGE model states are very close. This proximity allows us to propagate monetary policy and technology innovations in an otherwise non-structural dynamic factor model to obtain predictions for many more series than just a handful of traditional macro variables, including measures of real activity, price indices, labor market indicators, interest rate spreads, money and credit stocks, and exchange rates.