In this paper we present and estimate a stochastic dynamic general equilibrium (SDGE) model for the euro area. Following Christiano, Eichenbaum and Evans (CEE, 2001) it features a relatively large number of frictions that appear to be necessary to capture the empirical persistence in the main euro area macroeconomic data. Many of these frictions have become quite standard in the SDGE literature. Following Kollman (1997) and Erceg, Henderson and Levin (2000), the model exhibits both sticky nominal prices and wages that adjust following a Calvo mechanism. However, the introduction of partial indexation of the prices and wages that can not be re-optimised results in a more general dynamic inflation and wage specification that will also depend on past inflation. Following Greenwood, Hercowitz, and Huffmann (1988) and King and Rebelo (2000) the model incorporates a variable capital utilisation rate. This tends to smooth the adjustment of the rental rate of capital in response to changes in output. As in CEE (2001), the cost of adjusting the utilisation rate is expressed in terms of consumption goods. We also follow CEE (2001) by modelling the cost of adjusting the capital stock as a function of the change in investment, rather than the level of investment as is commonly done. Finally, external habit formation in consumption is used to introduce the necessary empirical persistence in the consumption process (See Fuhrer (2000) and McCallum and Nelson (1999)).

While the model used in this paper has many elements in common with that used in CEE (2001), the analysis differs in two main respects. First, we introduce a full set of structural shocks to the various structural equations. Next to two “supply” shocks, a productivity and a labour supply shock, we add two “demand” shocks, a preference shock and a cost-of-capital (or investment) shock, a “cost-push” shock (modelled as a shock to the mark-up equation) and two monetary policy shocks. We estimate the parameters of the model and the stochastic processes governing the structural shocks using seven key macroeconomic time series in the euro area: real GDP, consumption, investment, the GDP deflator, the real wage, employment and the nominal short-term interest rate. The estimation methodology can be viewed as a constrained maximum likelihood procedure, whereby the usual likelihood criterion is augmented by a condition that the model-based cross-covariances can not be too different from their empirical counterparts estimated using an unrestricted VAR.