The Pruned State-Space System for Non-Linear DSGE Models: Theory and Empirical Applications

This paper studies the pruned state-space system for higher-order perturbation approximations to DSGE models. We show the stability of the pruned approximation up to third order and provide closed-form expressions for first and second unconditional moments and impulse response functions. Our results introduce GMM estimation and impulse-response matching for DSGE models approximated up to third order and provide a foundation for indirect inference and SMM. As an application, we consider a New Keynesian model with Epstein-Zin preferences and two novel feedback effects from long-term bonds to the real economy, allowing us to match the level and variability of the $10-year term premium in the U.S. with a low relative risk aversion of $5.

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