DP3701 VARs, Common Factors and the Empirical Validation of Equilibrium Business Cycle Models

Author(s): Domenico Giannone, Lucrezia Reichlin, Luca Sala
Publication Date: January 2002
Keyword(s): dynamic factor models, equilibrium business cycle models, identification, structural VARs
JEL(s): C33, C52, E32
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3701

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.