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Title: VARs, Common Factors and the Empirical Validation of Equilibrium Business Cycle Models

Author(s): Domenico Giannone, Lucrezia Reichlin and Luca Sala

Publication Date: January 2002

Keyword(s): dynamic factor models, equilibrium business cycle models, identification and structural VARs

Programme Area(s): International Macroeconomics

Abstract: Equilibrium business cycle models have typically less shocks than variables. As pointed out by Altug, 1989, and Sargent, 1989, if variables are measured with error, this characteristic implies that the model solution for measured variables has a factor structure. This Paper compares estimation performance for the impulse response coefficients based on a VAR approximation to this class of models and an estimation method that explicitly takes into account the restrictions implied by the factor structure. Bias and mean squared error for both factor based and VAR based estimates of impulse response functions are quantified using, as a data generating process, a calibrated standard equilibrium business cycle model. We show that, at short horizons, VAR estimates of impulse response functions are less accurate than factor estimates while the two methods perform similarly at medium and long run horizons.

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Bibliographic Reference

Giannone, D, Reichlin, L and Sala, L. 2002. 'VARs, Common Factors and the Empirical Validation of Equilibrium Business Cycle Models'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=3701