Discussion Paper Details

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Title: Are small scale VARs useful for business cycle analysis? Revisiting Non-Fundamentalness

Author(s): Fabio Canova and Mehdi Hamidi Sahneh

Publication Date: January 2016

Keyword(s): aggregation, Granger causality, non-fundamentalness and small scale VARs

Programme Area(s): Monetary Economics and Fluctuations

Abstract: Non-fundamentalness arises when observables do not contain enough information to recover the vector of structural shocks. Using Granger causality tests, the literature suggested that many small scale VAR models are non-fundamental and thus not useful for business cycle analysis. We show that causality tests are problematic when VAR variables are cross sectionally aggregated or proxy for non-observables. We provide an alternative testing procedure, illustrate its properties with a Monte Carlo exercise, and reexamine the properties of two prototypical VAR models.

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Bibliographic Reference

Canova, F and Hamidi Sahneh, M. 2016. 'Are small scale VARs useful for business cycle analysis? Revisiting Non-Fundamentalness'. London, Centre for Economic Policy Research.