Working with Epstein-Zin Preferences: Computation and Likelihood Estimation of DSGE Models with Recursive Utility

Joint with: Jules H. van Binsbergen, Ralph S.J. Koijen and Juan F. Rubio-Ramírez

This paper illustrates how to efficiently compute and how to perform likelihood-based inference in dynamic stochastic general equilibrium (DSGE) models with Epstein-Zin preferences. This class of preferences has recently become a popular device to account for asset pricing observations and other phenomena that are challenging to address within the traditional state-separable utility framework. However, there has been little econometric work in the area, particularly from a likelihood perspective, because of the difficulty in computing an equilibrium solution to the model and in deriving the likelihood function. To fill this gap,

we build a real business cycle model with Epstein-Zin preferences and long-run growth, solve it with perturbation techniques, and evaluate its likelihood with the particle filter. We estimate the model by maximum likelihood using U.S. macro and yield curve data. We find a low elasticity of intertemporal substitution (around 0.06) and a large risk aversion (around 46). With our estimates, we evaluate the cost of aggregate ‡fluctuations to be around 9 percent of lifetime consumption.

For more information, contact Dirk Krueger.