Monetary Transmission Channels in DSGE Models: Decomposition of Impulse Response Functions Approach

Abstract

The paper presents decomposition of impulse response functions (IRFs) as a new diagnostic tool for dynamic stochastic general equilibrium (DSGE) models. This method works with any DSGE model of arbitrary complexity or theoretical background. It is also applicable to any policy transmission channels. We illustrate it with monetary transmission mechanisms in two New Keynesian general equilibrium models: QUEST_III model of the European Commission and Smets–Wouters model of the USA economy. For that purpose, we use DYNARE platform for solving the models and provide a MATLAB file for IRFs decomposition. The underlying software can handle decomposition of IRFs using both the first-order and the second-order approximation of Taylor series to equilibrium relations. An IRF aggregates partial contributions of all state variables to impulse responses of a model’s variable to a stochastic shock. The IRF decomposition identifies individual contributions of state variables and marks each particular channel that a policy shock uses to propagate throughout the model. We show in two illustrated cases that monetary transmission channels might be quite distinct even if DSGE models employ the same (Taylor) policy rule and reveal similar IRFs. More specifically, IRFs initiated by a monetary shock might misrepresent the pure interest rate impact on some variables. Decomposition of monetary IRFs casts more light on flexibility needed in an economy to contain negative impact of a monetary shock.