Evaluating Asset Pricing Implications of DSGE Models

Abstract

This paper conducts an econometric evaluation of structural macroeconomic asset pricing models. A one-sector dynamic stochastic general equilibrium model (DSGE) with habit formation and capital adjustment costs is considered. Based on the log-linearized DSGE model, a Gaussian probability model for the joint distribution of aggregate consumption, investment, and a vector of asset returns R(t) is specified. We facilitate the stochastic discount factor M(t) representation obtained from the DSGE model and impose the no-arbitrage condition E[M(t)R(t)|t-1]=1. In addition to the full general equilibrium model, we also consider consumption and production based partial equilibrium specifications, and a more general reference model. To evaluate the various asset pricing models we compute posterior model probabilities and loss function based measures of model adequacy.