Abstract
A factor structure for VAR model error terms is adopted to examine the dynamic relationships of major macroeconomic time series. The structure, which is testable, is used to trace the consequences of a contemporaneously “ceteris paribus” (or idiosyncratic) change in each variable in the VAR model. The impulse responses to idiosyncratic shocks are shown to be a dynamic representation of the Granger causality. In the analyses of the US monthly data from 1954 to 2011 for four key variables, inflation is found to respond negatively (positively) to an increase in unemployment (the federal funds rate), holding other variables contemporaneously fixed. The real variables (output and unemployment) appear unresponsive to idiosyncratic changes in the nominal variables (the federal funds rate and inflation). A common factor is observed to have a positive effect on unemployment and negative effects on output, inflation and the federal funds rate.
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Notes
Rudebusch (1998) argues that the FFR equation in a VAR does not approximate the US Federal Reserves’ reaction function well because the information available to econometricians is different from that available to the US Federal Reserve and the reaction function itself changes over time. Sims (1992) also points out that the results from a VAR may not be reliable if the monetary policy authorities have better information about future inflation than that obtainable from the variables in the VAR.
The estimation of the standard errors is difficult when the impulse responses are close to zero. Under such circumstances, the delta method and usual bootstrap techniques may produce unreliable estimates (see Benkwitz et al. 2000).
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This paper benefited from conversations with Lance Fisher, Glenn Otto and Adrian Pagan. I thank Robert Kunst (Editor) and two anonymous referees for their comments that led to many improvements to the paper. I am responsible for all remaining errors.
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Yang, M. Effects of idiosyncratic shocks on macroeconomic time series. Empir Econ 53, 1441–1461 (2017). https://doi.org/10.1007/s00181-016-1184-3
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DOI: https://doi.org/10.1007/s00181-016-1184-3
Keywords
- Vector autoregression
- Error factor
- Identification
- Granger causality
- Impulse responses
- Phillips curve
- Monetary neutrality