# Constant term in the measurement equation of Merola (2004)

Hello everyone,

I am working with the codes provided by dynare for the paper Rossana Merola (2014), “The role of financial frictions during the crisis: an estimated DSGE model

She uses the spread between BAA and AAA bonds yields as an observable (sobs) for the spread between the risk free interest rate and the external fundings interest rate for entrepreneurs (prem). The measurement equation that they use is:
sobs = prem;

I do not unsterstand why she does not include a constant term in the measurement equation since this premium in the model is defined in deviations from the steady state. Moreover, all observables included in dynare should be zero mean. As far as I understand the measurement equation should be something like:

sobs = prem + (constef - conster);

where constef is the steady state value of external fundings interest rate and conster is the steady state value of risk free interest rate.

Any help is really appreciated.

Not seen the paper, but perhaps she assumed that
(constef - conster)=0

so that in the long run, there is no spread?

Cheers
Reuben

If I read the paper correctly, everything was linearized, so the observed variables have been demeaned as well.

First of all, thank you very much for the replies.

1. As far as I understood the premium in the model is justified by the existence of an idiosyncratic shock that affects to the entrepreneurs’ returns of capital. In order to observe this shock the banks should pay a monitoring cost and therefore they offer a higher rate for funding these entrepreneurs’ projects. Therefore the premium should still exist in the steady state.

2. All the equations are linearized, but taking a look of the data and code provided by dynare (dynarewp033 (1).zip (96.3 KB)) I find that the spread (sobs) is not demeaned in the excel file (it has a mean of 0.238) and in the mod file the measurement equation does not include a constant term to subtract this mean.

I do not know if I am missing something else.
I am looking forward to hearing your opinion