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Title: Common Component Structural VARs

Author(s): Mario Forni, Luca Gambetti, Marco Lippi and Luca Sala

Publication Date: December 2020

Keyword(s): Nonfundamentalness, structural factor models and structural VAR models

Programme Area(s): Monetary Economics and Fluctuations

Abstract: Small scale VAR models are subject to two major issues: first, the information set might be too narrow; second, many macroeconomic variables are measured with error. The two features produce distorted estimates of the impulse response functions. We propose a new procedure, called Common Components Structural VARs (CC-SVAR), which solves both problems. It consists in (a) treating the variables, prior to estimation, in order to extract their common components; this eliminates measurement errors; (b) estimating a VAR with m > q common components, that is a singular VAR, where q is the number of shocks driving the economy; this solves the fundamentalness problem. SVARs and CC-SVARs are compared in the empirical analysis of monetary policy and technology shocks. The results obtained by SVARs are not robust, in that they strongly depend on the choice and the treatment of the variables considered. On the contrary, using CCSVARs (i) contractionary monetary shocks produce a decrease of prices independently of the variables included in the model, (ii) irrespective of whether hours worked enter the model in log-levels or growth rates, technology improvements produce an increase in hours worked.

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Bibliographic Reference

Forni, M, Gambetti, L, Lippi, M and Sala, L. 2020. 'Common Component Structural VARs'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=15529