Multivariate Models Iii Structural Vars: How Do We Choose Between Uvar, Svar, Cvar (Vecm) ?
Multivariate Models Iii Structural Vars: How Do We Choose Between Uvar, Svar, Cvar (Vecm) ?
Multivariate Models Iii Structural Vars: How Do We Choose Between Uvar, Svar, Cvar (Vecm) ?
Structural VARs
Review of Methodologies:
Univariate models:
AR, MA, ARIMA models. Must be stationary to model them as ARMA.
Nonstationary models – spurious regressions. Nonstationarity tests (ADF, PP, etc.).
Ref: Enders Ch.5, Favero Ch.6, Bernanke and Mihov (1998, QJE), Blanchard and Quah
(1989, AER)
Or in matrix form:
1 b12 yt b10 c11 c12 yt 1 yt
(3)
b21 1 zt b20 c21 c22 zt 1 zt
More simply:
(4) BX t 0 1 X t 1 t
Error terms are composites of the structural innovations from the primitive system.
e1t 1 1 b12 yt
(7) et B 1 t
e2t (1 b21b12 ) b21 1 zt
Or
yt b12 zt b21 yt zt
e1t e2 t where 1 b21b12
Identification
To get the effect of a structural innovation on the dependent variables we recover the
parameters for the primitive system from the estimated system.
VAR: 9 parameters; SVAR: 10 parameters, underidentified.
A triangular Cholesky decomposition makes the SVAR exactly identified: impose the 0
condition on b12 or b21 .
Sims (1986), Bernanke (1986) proposed using theory to derive the identifying restrictions
in B:
Estimation gives the error terms e defined as et B 1 t so
t Bet .
More formally:
et B 1 t Eet e't EB 1 t 't ( B 1 )' B 1 E ( t 't )( B 1 )'
Hence: B 1 ( B 1 )'
( nxn ) ( nxn ) ( nxn ) ( nxn )
n n
2 B: :
2 n2 n n
knowns unkowns unknowns
t 1 2 3 4 5 E (eit )
e1t 1 -0.5 0 -1 0.5 0
e2t 0.5 -1 0 -0.5 1 0
E (e1t ) 2
2
1 0.5 22
5
E (e1t e2t )
12 0.4 21
5
Hence
Var ( y ) 0 1 b12 0.5 0.4 1 b21
0
Var ( z ) b
21 1 0.4 0.5 b12 1
The 2nd and the third equations are identical. So we need another restriction to solve the
relations:
yt e1t b12e2 t
zt b21e1t e2t
Numerically:
Var ( y ) 0.5
0 0.4 0.5b21 b21 0.8 Var ( z ) 0.18
Var ( z ) 0.5 0.8b21 0.5b 2
21
t 1 2 3 4 5 E ( it )
yt e1t 1 -0.5 0 -1 0.5 0
zt -0.3 -0.6 0 0.3 0.6 0
and
yt 1 1 e1t
1 1 e
zt 2t
1 2 e1t
b. b12 b21 2 yt
zt 2 1 e2t
(iv) VAR restriction on variances of structural shocks: multiple solutions for coefficients
of B.
ex: Var ( yt ) 1.8
Var ( y ) 0.5 0.8b12 0.5b12
2
1.8 b12 (1,2.6)
1 1 e1t
a. b12 1 b21 1 yt
zt 1 1 e2t
1 2.6 e1t
b. b12 2.6 b21 5 / 3 yt
zt 5 / 3 1 e2t
Choleski ordering:
zt ( yt , pt , mt )
Although there is no formal model, the VAR is based on a standard theoretical model :
y is exogenous, only affected by its own shocks (output equation)
p is affected contemporaneously by its own shocks but also by y shocks and it is not
affected by m shocks (from an inflation equation such as PC).
m is affected by its own and the two other shocks (money demand equation).
Despite the appeal of this methodology, researchers had to deal with several persistent
counterintuitive results in both closed economy and open economy VAR MODELS:
Closed economy
Liquidity Puzzle: a typical finding was not to find the familiar liquidity effect (an inverse
relation between a money market shock and interest rates). A money market shock
increases the interest rate, instead of decreasing it.
Literature background
Early research: increases in MS reduce interest rates (Gibson 1968, QJE, Cagan
and Gandolfi, 1968 AER P&P).
Research in 1980s no good news: this effect disappears in the 1970s. Tests started
to focus on unanticipated changes in policy –Rational expectations revolution—.
Findings: Correlations between innovations in M and i.r. positive or
insignificant; announcements of MS larger than expected associated with
increases in ST i.r.
Recent literature mixed:
Findings: eliminating high frequency movements in MS and i.r.
reestablished some LE for subsamples (Cochrane, 89). LE is supported if
(i) there is LR identification consisting of M neutrality (Gali, 92); (ii)
emphasis on bank reserves and the FF rate (Strongin, 95). But an equal
number of studies show that evidence supports the a positive relation
between liquidity and i.r.
Price Puzzle: a positive interest rate shock (contractionary monetary policy) leads to
persistent rise in the price level. A tightening of MP generally is expected to reduce the P
level, not increase it. Result holds for other countries as well and is especially
pronounced if short-term interest rate is taken to be the policy instrument rather than a
monetary aggregate.
Non-neutrality of money in the LR: a wide consensus in the literature is that money has
real effects in the short run but it is neutral in the long run, and changes in the MS do not
have a LR effect on the real variables such as output, employment, real interest rates, real
money balances.
Both old and recent studies including VAR analysis (1960s-1990s) finds that changes in
MP lead to long, protracted response in real variables.
Open economy
In addition to the usual closed economy variables, the crucial variable included to the list
is the bilateral exchange rate along with the foreign variables.
Exchange-rate puzzle: Theory predicts the higher the return on foreign investment, the
higher should be the demand for the currency, which should appreciate and, therefore, the
dollar should depreciate.
VAR results show the opposite: A restrictive foreign monetary policy (i* shock) leads to
an appreciation of the US$.
The vector of policy indicators have information about policy but also affected by macro
variables: P depends on current and lagged values of Y and P and disturbances, one of
them being a MS shock v s . Y depends on its current and lagged values and on lagged
values of P. Note that there is a block exogeneity assumption, in the sense that P does not
enter Y during the same period, while Y (and P) does enter P during the period. This
means that innovations to policy variables do not feedback to the economy
contemporaneously. The v y and v p are the unobservable, structural shocks, which we
want to retrieve. In particular v p [v d v b v s ] , representing TR demand shock,
disturbance to the borrowing function and shock to the stance of MP, respectively.
This is in SVAR system that relates the observed VAR-based residuals u to unobserved
structural shocks v, including v s . We can identify the system and recover the structural
shocks, in particular MS shock, using the impulse response functions.
For identification, B&M consider a model of the market for commercial bank reserves
and Fed’s operating procedures expressed in innovation form:
(8) uTR u FF v d
Commercial banks’ total demand for reserves: innovation in the demand for total reserves
(TR) falls with innovation in the Fed fund rate (FF) and rises with a demand disturbance.
(9) u BR u FF v b
Portion of reserves banks choose to borrow at the discount window: Innovation in the
demand for BR rises with innovations in the Fed fund rate and a disturbance term.
(10) u NBR d v d b v b v s
Behavior of FRB: The Fed sets the innovation to the supply of NBR. In doing so, it
observes the structural innovations to the demand for TR and BR and responds to
structural shocks to TR, BR and MS.
1 1 1
1 FF 0 0 vb
u
0 u 0
TR
1 1 0 v d
0 1 u NBR b
0 d 1 v s
u FF 0 0 1 /( ) v b
TR
u 0 1 /( ) v d (check)
u NBR b d 1 v s
# knowns = (n2+n)/2=12/2=6 (estimated from covariances of u’s, the policy block UVAR
residuals)
# unkowns = 4 parameters + 3 structural variances = 7.
The model is underidentified.
1. Overidentifying SR restrictions
(i) Federal funds targeting
The Fed fully offsets shocks to TR demand and BR demand: b 1 and d 1
u FF 0 0 1 /( ) v B
TR
u 0 1 /( ) v D
u NBR 1 1 1 v S
u FF 0 0 1 /( ) v B
TR
u 0 1 /( ) v D
u NBR 0 0 1 v S
u FF 0 0 1 / v B
TR
u 0 1 0 v D
u NBR 0 d 1 v S
u FF 0 0 1 /( ) v B
TR
u 0 1 /( ) v D
u NBR / 1 1 v S
negative of BR innovations.
The previous restrictions were overidentifying the model. Their test is done according to
the overidentifying restriction.
With a just-identified model, you can check how well the parameters estimated compare
with the predictions of the alternative models.
yt ip1 Ai yt i Bvt
where y {LY , UN } growth rate of GDP and unemployment, both I(0) and v={v1, v2}
where v1 is an AD shock and v2 is an AS shock.
B&Q decompose the shock into a temporary and a permanent one by assuming that the
effect of the demand shock on output is temporary (dies out in the LR) and the effect of
supply shock is permanent. But both the demand and the supply shocks are not
observable. Hence, they propose to recover them from the VAR estimation.
Get the coefficients of from estimates and impose LR restrictions. Note that for
to be invertible VAR must have stationary variables.
I ip1 Ai L 1 b11
b12 v1t
k
11
k12 b11
k 22 b21
b12 v1t
b22 v2t
b21 b22 v2t k 21
Application
Identifying restrictions: you can choose SR or LR restrictions, not both. You can specify by text or
matrix. For the latter you need to create a “pattern” matrix and set the coefficients values. Do this if you
have a large model with lots of constraints. Otherwise go with “by text”.
By text
We have:
LYt k11 k12 b11 b12 v1t C1 C2 v1t
UN k
t 21 k 22 b21 b22 v2t C4 C3 v2t
In Eviews notation,
X=Cv
Av = Bu
(Note that A and B are switched compared to our notation:
X t B 10 B 11 X t 1 B 1 t e B 1 A where A is identity matrix)
Here v is the vector of observable errors, u is the vector of pure shocks and
C ( I A1 A2 ....) A1 B (1) A1 B is the estimated accumulated responses to
observed shocks. Long-run restrictions are imposed by setting elements of C to zero.
We want to set the LR response of the first variable to the first structural shock (demand
shock) to zero: C11 0 (here: C1 0 ).
@lr# : the symbol # stands for the response variable that we want to restrict. If you wanted to restrict the
response of the 2nd variable to the first shock then write: @lr2(@u1)
(@u&) : the impulse & that you want to restrict the effect on the variable specified in #.
=0 : to how much you want to restrict the response of # to an impulse in &.
Structural VAR Estimates
Date: 05/03/07 Time: 09:32
Sample (adjusted): 1953Q2 1990Q4
Included observations: 151 after adjustments
Estimation method: method of scoring (analytic derivatives)
Convergence achieved after 7 iterations
Structural VAR is just-identified
Estimated A matrix:
1.000000 0.000000
0.000000 1.000000
Estimated B matrix:
0.845159 0.286935
-0.248859 0.154010
In the literature, it is common to assume that structural innovations have a diagonal covar matrix. To
compare these results to the literature, divide each column of B by the element on its diagonal.
1 b12 / b22
B
b21 / b11 1
A0 yt ip1 Ai yt i Bvt
yt s
Cs
vt
IRF: The effect of a shock to jth element on the ith element when all the other shocks are
kept constant.
yi ,t s
Ci , j , s
v j ,t
This can be calculated if the shocks are orthogonal, such as the structural shocks. Not
possible with the VAR shocks, which are correlated (must impose an identification
scheme such as Choleski).
A triangular VAR:
A0 zt ip1 Ai zt i Bvt
The B matrix is diagonal and A is lower triangular.
Results:
Forward-discount puzzle.
Same response of US P and Y to monetary shocks as in closed economy.
Exchange-rate puzzle.
The response of q to US and foreign MP similar to the response of e,
suggesting sluggishness in prices.
A0 z t ip1 Ai z t i Bv t
B is a diagonal matrix,
1 0 0 0 0 0 0
a 1 0 0 0 0 0
21
a 31 0 1 0 0 0 0
A0 a 41 0 a 43 1 0 0 0 and z t (opwt , ff t , y t *, p t *, mt *, i t *, et )
0 0 a 53 a 54 1 a 56 0
a 61 0 0 0 a 65 1 a 67
a a 72 a 73 a 74 a 75 a 76 1
71
Identifying restrictions:
The US econ is exogenous. The US Y and P not in the VAR.
The e.r. does not enter the Fed’s reaction function.
Feedback between the US and foreign MP: US MP enters foreign MP through its
interaction with the e.r.
The e.r. contemporaneously reacts to all other shocks.
Results:
Puzzles disappear.
Most of the closed economy results are replicated by impulse response functions.
But questions remain: only two parameters are precisely estimated (a56=dm*/dy* and
a72=de/dff), and the meaning of a56 is not clear (S shock or D shock?). Hanson’s
comments for closed economy and liquidity puzzle still remains: what resolves the
puzzle?
Cushman and Zha (1997, JME) introduce the trade sector for Canadian economy.
Smets (1997 BIS WP) exclude US variables and commodity prices but impose BQ
identification scheme: in the LR the effect of demand shocks on output is zero.
Other questions/controversies:
Which choice of policy instrument? i, m or other?
Bernanke and Blinder (1992, AER): fedfund rate (=market interest rate for overnight US$
loans by banks).
Eichenbaum (1992, EER): M0 because it has a less significant price-puzzle.
1. UVAR
VAR (varopen0):
We will run a VAR on levels using US real GDP, USCPI, German real GDP, German call
money rate, exchange rate (DM per 1$US: a rise is an appreciation of the $). All
variables are in logs, except the interest rates:
y (lusy), p (luscp), i (usff), y* (lgery), p* (lgercp), i* (gercmr), e (lusdm)
Lags: 6
UVAR
.006 .006
.004 .004
.002 .002
.000 .000
-.002 -.002
-.004 -.004
-.006 -.006
5 10 15 20 25 30 35 40 45 50 5 10 15 20 25 30 35 40 45 50
.002
.002
.000
.000
-.002
-.002
-.004
-.004
5 10 15 20 25 30 35 40 45 50
5 10 15 20 25 30 35 40 45 50
.015 .015
.010 .010
.005 .005
.000 .000
-.005 -.005
-.010 -.010
5 10 15 20 25 30 35 40 45 50 5 10 15 20 25 30 35 40 45 50
Add pcm first in the Cholesky ordering and three break points.
lpcm lusy luscp usff lgery lgercp gercmr lusdm
Lags: 6
UVAR: varopen
.01
.01
.00
.00
- .01
- .01
- .02
5 10 15 20 25 30 35 40 45 50 - .02
5 10 15 20 25 30 35 40 45 50
.00 2 .00 2
.00 1 .00 1
.00 0 .00 0
- .00 1 - .00 1
- .00 2 - .00 2
- .00 3 - .00 3
- .00 4 - .00 4
5 10 15 20 25 30 35 40 45 50 5 10 15 20 25 30 35 40 45 50
.00 4
.00 4
.00 0
.00 0
- .00 4
- .00 4
- .00 8
- .00 8
5 10 15 20 25 30 35 40 45 50
5 10 15 20 25 30 35 40 45 50
.00 1 .00 1
.00 0 .00 0
- .00 1 - .00 1
- .00 2 - .00 2
5 10 15 20 25 30 35 40 45 50 5 10 15 20 25 30 35 40 45 50
.2 .2
.1 .1
.0
.0
- .1
- .1
- .2
- .2
- .3
- .4 - .3
5 10 15 20 25 30 35 40 45 50
5 10 15 20 25 30 35 40 45 50
.01
.01
.00
.00
- .01
- .01
- .02
- .02
5 10 15 20 25 30 35 40 45 50
5 10 15 20 25 30 35 40 45 50
2. Short-Run restrictions: SVAR
After running the UVAR(6) with sample 1970.1-2004.12 and dummies, click
proc
structural factorization
then type in your restrictions for each equation (7 restrictions here), such as
@e1=c(1)*@u1 (innovations to pcm are exogenous: they are not affected by the other
innovations)
@e1=c(1)*@u1
@e2=-c(2)*@e1+c(3)*@u2
@e3=-c(4)*@e1-c(5)*@e2+c(6)*@u3
@e4=-c(7)*@e1-c(8)*@e2-c(9)*@e3+c(10)*@u4
@e5=-c(11)*@e1+c(12)*@u5
@e6=-c(13)*@e1-c(14)*@e5+c(15)*@u6
@e7=-c(16)*@e1-c(17)*@e4-c(18)*@e5-c(19)*@e6+c(20)*@u7
@e8=-c(21)*@e1-c(22)*@e2-c(23)*@e3-c(24)*@e4-c(25)*@e5-c(26)*@e6-
c(27)*@e7 +c(28)*@u8
Estimated A matrix:
1.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000
-0.018207 1.000000 0.000000 0.000000 0.000000 0.000000 0.000000
-0.005520 -0.027026 1.000000 0.000000 0.000000 0.000000 0.000000
3.395368 -26.49765 -30.85571 1.000000 0.000000 0.000000 0.000000
0.058473 0.000000 0.000000 0.000000 1.000000 0.000000 0.000000
-0.013780 0.000000 0.000000 0.000000 -0.012357 1.000000 0.000000
0.256565 0.000000 0.000000 -0.017476 -2.672097 25.21627 1.000000
0.236355 -0.687508 -0.485800 -0.006826 -0.010322 -1.808124 -0.008052
Estimated B matrix:
0.019031 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000
0.000000 0.006298 0.000000 0.000000 0.000000 0.000000 0.000000
0.000000 0.000000 0.002037 0.000000 0.000000 0.000000 0.000000
0.000000 0.000000 0.000000 0.596943 0.000000 0.000000 0.000000
0.000000 0.000000 0.000000 0.000000 0.015340 0.000000 0.000000
0.000000 0.000000 0.000000 0.000000 0.000000 0.002430 0.000000
0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.300670
0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000
Here we got (10) = 13.85 < 18.31 at 5% do not reject the null. But many coefficients
2
are not significant. So you can go back and refine the restrictions.