Limited asset market participation and the euro area crisis: an empirical dsge model

We estimate a medium-scale dynamic stochastic general equilibrium model for the Euro area with limited asset market participation (LAMP). Our results suggest that in the recent European Monetary Union years LAMP is particularly sizable (39% during 1993-2012) and important to understand business cycle features. The Bayes factor and the forecasting performance show that the LAMP model is preferred to its representative household counterpart. In the representative agent model the risk premium shock is the main driver of output volatility in order to match consumption correlation with output. In the LAMP model this role is played by the investment-specific shock, because non-Ricardian households introduce a Keynesian multiplier effect and raise the correlation between consumption and investments. We also detect the contractionary role of monetary policy shocks during the post-2007 years. In this period consumption of non-Ricardian households fell dramatically, but this outcome might have been avoided by a more aggressive policy stance. (JEL C11, C13, C32, E21, E32, E37)