DP11041 Are small scale VARs useful for business cycle analysis? Revisiting Non-Fundamentalness

Author(s): Fabio Canova, Mehdi Hamidi Sahneh
Publication Date: January 2016
Keyword(s): aggregation, Granger causality, non-fundamentalness, small scale VARs
JEL(s): C32, C5, E5
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11041

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.