Model Validation and DSGE Modeling

Abstract

The primary objective of this paper is to revisit DSGE models with a view to bringing out their key weaknesses, including statistical misspecification, non-identification of deep parameters, substantive inadequacy, weak forecasting performance, and potentially misleading policy analysis. It is argued that most of these weaknesses stem from failing to distinguish between statistical and substantive adequacy and secure the former before assessing the latter. The paper untangles the statistical from the substantive premises of inference to delineate the above-mentioned issues and propose solutions. The discussion revolves around a typical DSGE model using US quarterly data. It is shown that this model is statistically misspecified, and when respecified to arrive at a statistically adequate model gives rise to the Student&rsquo;s <i>t</i> VAR model. This statistical model is shown to (i) provide a sound basis for testing the DSGE overidentifying restrictions as well as probing the identifiability of the deep parameters, (ii) suggest ways to meliorate its substantive inadequacy, and (iii) give rise to reliable forecasts and policy simulations.