An application of business cycle accounting with misspecified wedges

It is often assumed that wedges evolve according to VAR(1)VAR(1) in the applications of business cycle accounting (BCA). However, recent research finds that the wedges have no VAR(1)VAR(1) representation in many dynamic stochastic general equilibrium (DSGE) economies, and that there might be a misspecification of the stochastic process of wedges. In order to assess the empirical usefulness of BCA, we apply BCA to a widely used medium-scale DSGE economy. Based on our experiments, we find that the accuracy of the measurement of wedges is high enough to capture the business cycle implications of wedges.

► The VAR(1)VAR(1) specification of wedges is often assumed in business cycle accounting (BCA).
► Recent research finds that there is no VAR(1)VAR(1) form of wedges in many DSGE economies.
► There might be a misspecification of the stochastic process of wedges.
► We apply BCA to a medium-scale DSGE economy.
► The accuracy of the measurement of wedges is high enough to capture the business cycle implications of wedges.