UC Berkeley

Macroeconomic models typically focus on innovations in the level of fundamentals as driver of business cycles because modeling of volatility can be demanding. This paper suggests a simple methodology that can separate the level from the volatility factors without directly estimating the volatility processes. This is made possible by exploiting features in the second order approximation of equilibrium models and using information in a large panel of data to estimate the factors. Augmenting the factors to a VAR shed light on the effects of the level and volatility shocks and their relative importance.