Correlated Disturbances and U.S. Business Cycles - FEDERAL RESERVE BANK of NEW YORK

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Staff Reports

Correlated Disturbances and U.S. Business Cycles

February 2010 Number 434

JEL classification: E30, E10

Authors: Vasco Cúrdia and Ricardo Reis

The dynamic stochastic general equilibrium (DSGE) models used to study business cycles typically assume that exogenous disturbances are independent first-order autoregressions. This paper relaxes this tight and arbitrary restriction by allowing for disturbances that have a rich contemporaneous and dynamic correlation structure. Our first contribution is a new Bayesian econometric method that uses conjugate conditionals to allow for feasible and quick estimation of DSGE models with correlated disturbances. Our second contribution is a reexamination of U.S. business cycles. We find that allowing for correlated disturbances resolves some conflicts between estimates from DSGE models and those from vector autoregressions and that a key missing ingredient in the models is countercyclical fiscal policy. According to our estimates, government spending and technology disturbances play a larger role in the business cycle than previously ascribed, while changes in markups are less important.

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47 pages / 563 kb

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