# Chapter 1. Vector autoregressions. 1.1 VARs and the identi cation problem

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1 Chapter Vector autoregressions We begin by taking a look at the data of macroeconomics. A way to summarize the dynamics of macroeconomic data is to make use of vector autoregressions. VAR models have become increasingly popular in recent decades. They are estimated to provide empirical evidence on the response of macroeconomic variables to various exogenous impulses in order to discriminate between alternative theoretical models of the economy. This simple framework provides a systematic way to capture rich dynamics in multiple time series, and the statistical toolkit that came with VARs was easy to use and to interpret. As Sims (98) and others argued in a series of in uential early papers, VARs held out the promise of providing a coherent and credible approach to data description, forecasting, structural inference and policy analysis.. VARs and the identi cation problem A VAR is an n equation, n variable model in which each variable is in turn explained by its own lagged values, plus (current) and past values of the remaining n variables. A VAR can be thought of as the reduced form of a dynamic economic system involving a vector of variables z t. That is, starting from the so-called structural form: Az t B z t + B z t + ::: + B p z t p + u t u Euu u u 6 7 ::: 5 un a VAR of lag length p (V AR (p)) can be written as z t A B z t + A B z t + ::: + A B p z t p + A u t We assume that each of the variables in z t is demeaned prior to estimation, so we can neglect constant terms in each of the equations. 8

2 .. VARS AND THE IDENTIFICATION PROBLEM 9 where E (u t ) ; E (u t u ) u for t ; and otherwise. Thus, a vector autoregression is a system in which each variable is expressed as a function of own lags as well as lags of each of the other variables. VAR s come in three varieties: reduced form, recursive and structural. In each case, what we want to solve is the identi cation problem. That is, our goal is to recover estimates of A; B; and u. In the examples below, we assume there is only one lag in the VAR. This comes without loss of generality, since higher order lags can be dealt exactly in the same way. REDUCED FORM Each variable is expressed as a linear function of its own past values and past values of all other variables. Each equation is estimated by OLS. The error terms are the surprise movements in the variables after taking past values into account. If the variables are correlated with each other, then the error terms will also be correlated. In practice, given the structural form, we estimate A B ; :::A B p and A u A ; but we cannot easily revert to the A s and the u that are our object of interest. RECURSIVE VAR A recursive VAR tries to identify the structure of the model by constructing the error term in each regression to be uncorrelated with the error in the preceding equations. This is done by estimating the equations of the VAR by carefully including in some of the equations the contemporaneous values of other variables as regressors. Consider for instance this bivariate VAR with equations and variables. Think about, say, a simple bi-variate model with only income and interest rates: in this model: a ry ; a yr ; b are the structural parameters; Y t a yr R t + b yr R t + b yy Y t + u yt () R t a ry Y t + b rr R t + b ry Y t + u rt () u rt, u yt are the uncorrelated structural shocks with standard deviation r and y. The equations cannot be estimated by OLS, since they violate the assumptions of the classical regression model of uncorrelation between the regressors and the error term. Suppose in fact that we estimate the second equation by OLS: the variable Y will be correlated with the error term, since: cov (Y t ; u rt ) cov ( a yr R t + b yr R t + b yy Y t + u yt ; u rt ) cov ( a yr (b rr R t + b ry Y t a ry Y t + u rt ) + b yr R t + b yy Y t + u yt ; u rt ) a yr a ry cov (Y t ; u rt ) a yr ur a yr cov (Y t ; u rt ) a yr a ur. ry

3 CHAPTER. VECTOR AUTOREGRESSIONS OLS estimates of equation will yield inconsistent estimates of the parameters of the model unless we assume that a yr ; that is the contemporaneous e ect of interest rate shocks on output is zero. Suppose then we impose a yr : Equation can be estimated by OLS. An interest rate shock u rt will have an e ect on R t equal to ; and on Y t of. An income shock u yt will have an e ect on Y t of ; and an e ect of a ry on R t. This way of proceeding is called recursive, since we can estimate one by one the equations by OLS but in a peculiar way: for equation, we exclude R t from the regressors; for equation, we include Y t among the regressors. To be more precise, consider estimation of the VAR described by Y and R; the structural model cannot be estimated by OLS: ayr a ry Yt R t but the reduced form: Yt ayr byy a ry R t b ry byy b ry b yr b rr b yr b rr Yt R t Yt R t + + uyt u rt ayr a ry uyt can be estimated by OLS; however, the error terms of the two equations are now correlated across equations, which means that we cannot identify the structural parameters from the residuals of the two equations! The residual of the two reduced form equations will be linked to the structural parameters by: u rt e t e t (u yt a yr a ry a yr u rt ) (u rt a yr a ry a ry u yt ) If a yr ; then: e t u yt e t u rt a ry u yt which implies that:. rst, we estimate the reduced form of the rst equation (regress Y on lagged Y and R) and we recover the structural shock u yt. If we had three variables with, say, R; Y and P, we would. exclude the contemporaneous values of Y and P them from the equation for R:. exclude the contemporaneous value of P from the equation for Y.. exclude no variable (that is, include P and Y contemporaneous) from the equation for R.

4 .. VARS AND THE IDENTIFICATION PROBLEM. We know that OLS estimates of are consistent once a yr : So, in order to recover u rt, we simply estimate R t a ry Y t +b rr R t +b ry Y t +u rt and calculate the residual. This way, from our dynamic system made by () and () ; we are able to estimate our structural parameters. In the VAR jargon, the algorithm for estimating the coe cients when more than one variable is involved does not go about estimating equation in reduced form, equation excluding as contemporaneous regressors the LHS variable of equation, and so on. What we normally do goes instead in two steps:. Estimate the reduced form for all equations. This can be done easily with any econometric / computational package.. Compute the Choleski decomposition of the variance-covariance matrix of the residuals. In general, for each symmetric, positive de nite matrix X; the Choleski decomposition is an upper triangular matrix U such that: Why? Denote a ry ; x. Then: X U U z t A Bz t + A u {z } t e t e A u u A A x y y x r r x x y y y y r r The last expression de nes a system of three equations above that be solved for: y x y x r For instance, the Choleski decomposition of a generic matrix is: a b b c " p a pb a qc a b # " p a pb # q a c a b

5 CHAPTER. VECTOR AUTOREGRESSIONS Computer programs have an easy way to do all of this. Note that: chol ( e ) u A So, rst you estimate the VAR in reduced form. Through the Choleski decomposition of e you recover a matrix that on the main diagonal has the standard deviation of all structural shocks. That is (I am using Matlab language here: given a matrix X; the command diag(diag(x)) returns a diagonal matrix with the elements of X on the main diagonal): u diag (diag (chol ( e ))) Next, you can calculate A and/or A. A is given by: A u chol ( e ) A chol ( e ) u STRUCTURAL VAR It uses economic theory to sort out the contemporaneous relationships between the variables. For instance, we might know from economic theory that a yr :. This type of assumption need not to involve only the contemporaneous e ect of shocks.. Impulse response functions In a VAR, we are often interested in obtaining the impulse response functions. Impulse responses trace out the response of current and future values of each of the variables to a one-unit increase (or to a one-standard deviation increase, when the scale matters) in the current value of one of the VAR errors, assuming that this error returns to zero in subsequent periods and that all other errors are equal to zero. The implied thought experiment of changing one error while holding the others constant makes most sense when the errors are uncorrelated across equations, so impulse responses are typically calculated for recursive and structural VARs. We begin by noticing that if we know A and u ; we can begin from: z t A Bz t + A u {z } t e t we can calculate the IRF s to a unit shock of u once we know A : Assume the system has been in steady state for a while. Suppose we are interested in tracing the dynamics to a or, using all of the above A u chol ( e ) diag (chol (e )) chol ( e )

6 .. FORECAST ERROR VARIANCE DECOMPOSITION (FEVD) shock to the rst variable in a two variable VAR: when a shock hits at time : u z Y R A u For every s > ; z s A Bz s. To summarize, the impulse response function is a practical way of representing the behavior over time of z in response to shocks to the vector u.. Forecast error variance decomposition (FEVD) Variance decomposition separates the variation in an endogenous variable into the component shocks to the VAR. Thus, the variance decomposition provides information about the relative importance of each random innovation in a ecting the variables in the VAR. Given our structural model: G (L) z t u t the VMA (vector moving average) representation of our VAR is: z t u t + u t + u t + :::: and the error in forecasting z t in the future is, for each horizon s: z t+s E t z t+s u t+s + u t+s + u t+s + :::: + s u t+ from which the variance of the forecasting error is: V ar (z t+s E t z t+s ) u + u + u + :::: + s u s on the basis of this formula, we can compute the share of the total variance of the forecast error for each variable attributable to the variance of each structural shock.. Vector autocovariances (VACF) A structural VAR is just one of the ways of summarize the second moment properties of a time-series process, and relies heavily on the implied assumption about the contemporaneous e ects of the shocks. In more general terms, however, we can nd another useful way to

7 CHAPTER. VECTOR AUTOREGRESSIONS summarize all the second moments for a vector of time series z t 5 following a V AR (p) process. The V AR (p) reduced form representation is: z t z t + z t + ::: + p z t p + e t. De ne the following variables: t np 6 z t z t ::: 7 5 F np v np 6 6 z t p+ ::: p p I n ::: ::: I n ::: ::: ::: ::: ::: ::: ::: :: I n e t ::: Then the V AR (p) above can be written as: Evv Q npnp 6 t F t + v t e ::: :: 7 < contemporaneous VCOV matrix :: :: :: :: 5 :: where notice that with just one lag: t z t, F A B, v e: Under stationarity conditions (we need to check that the eigenvalues of F all lie inside the unit circle, so that we can invert the VAR process), the VAR has a covariance stationary M A representation. We can then de ne the jth autocovariance as the following n n matrix: j Ez t z t j Remark Consider for instance the simple case j. Then Ez t zt is the contemporaneous covariance matrix of our time series, that is in the example with Y and R only: V AR (Yt ) cov (Y t ; R t ) cov (Y t ; R t ) V AR (R t ) 5 In general, each of the series has to be demeaned so as to avoid dealing with the constant term of the regression.

8 .5. EVIDENCE 5 notice that j j for a scalar, but not for a time series, for which in general j 6 j Remark Consider for instance the simple case j. Then Ez t zt : in the example with R and Y only E t Yt R t Y t R t since for instance cov (Y t ; R t+ ) 6 cov (R t ; Y t+ ) cov (Yt ; Y t ) cov (Y t ; R t ) cov (R t ; Y t ) cov (R t ; R t ) In practice, the autocovariances are calculated as follows: t F t + v t post-multiply by own transpose and take expectations E ( t t) F E t t F + E (v t v t) 6 F F + Q where ::: p ::: p ::: ::: ::: ::: p ::: ::: for lags greater than p; we postmultiply t by t 7 5 and then take expectations to obtain: t t j F t j t j + v t t j E t t j F E t j t j + E vt t j j F j Notice the intuition behind the autocovariance function for a VAR. For all the variables, we have an easy way to summarize all the dynamic cross-correlations between them, without making any sort of causality statement..5 Evidence With this background in mind, we try and see what the empirical VAR evidence shows: to this purpose, we run a simple -variable, -lag VAR on US quarterly data running from 96 to. Data are on log (GDP deflator), log (GDP ), log (M), Fed

9 6 CHAPTER. VECTOR AUTOREGRESSIONS P R Y M Y Response of Y Response of P Response of R Response of M Shock to P R M Response of Y Response of P Response of R Response of M Figure.: VAR evidence on US data

10 .6. IMPLICATIONS FOR MACROECONOMIC MODELLING. 7 Funds rate. See plot of the data and make sure you know what distances on the vertical axis measure. Impulse responses trace out the response of current and future values of each of the variables to a unit increase in the current value of one of the VAR structural errors, assuming that this error returns to zero thereafter. What shall we remember about the VAR evidence? Delays of monetary policy actions: peak response of output occurs several quarters after shock endogenous responses of interest rate (countercyclical policy): when shocks lead to a rise in output or prices, the nominal interest rate follows in the same direction; this might represent attempts on part of the policymaker to stabilize the economy. output-in ation trade-o : there are shocks that generate a positive correlation between output and prices, whereas other shocks move the variables in opposite directions. price puzzle: prices temporarily rise after a (contractionary) interest rate increase. money shocks are very persistent and suggest long-run elasticity of prices to money supply of, whereas at the same time they are neutral with respect to output in the long run..6 Implications for macroeconomic modelling. Today s macroeconomics is quantitative in many respects. Macroeconomists try and build dynamic, micro-founded models that are as close as possible to the evidence we presented today. The advantage of having micro-founded models are several:. they are in general elegant and nice. they can be used to evaluate the welfare e ects of alternative policy. we can do what if experiments with these models since their deep parameters, being based on preferences and technology, are in general robust to Lucas critique.

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