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Estimating US Monetary Policy Shocks Using a Factor-Augmented Vector Autoregression: An EM Algorithm Approach

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  • Bork, Lasse

    ()
    (Department of Business Studies, Aarhus School of Business)

Abstract

Economy-wide e¤ects of shocks to the US federal funds rate are estimated in a state space model with 120 US macroeconomic and financial time series driven by the dynamics of the federal funds rate and a few dynamic factors. This state space system is denoted a factor-augmented VAR (FAVAR) by Bernanke et al. (2005). I estimate the FAVAR by the fully parametric one-step EM algorithm as an alternative to the two-step principal component method and the one-step Bayesian method in Bernanke et al. (2005). The EM algorithm which is an iterative maximum likelihood method estimates all the parameters and the dynamic factors simultaneously and allows for classical inference. I demonstrate empirically that the same impulse responses but better fit emerge robustly from a low order FAVAR with eight correlated factors compared to a high order FAVAR with fewer correlated factors, for instance four factors. This empirical result accords with one of the theoretical results from Bai & Ng (2007) in which it is shown that the information in complicated factor dynamics may be substituted by panel information

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Bibliographic Info

Paper provided by University of Aarhus, Aarhus School of Business, Department of Business Studies in its series Finance Research Group Working Papers with number F-2009-03.

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Length: 68 pages
Date of creation: 01 Feb 2009
Date of revision:
Handle: RePEc:hhb:aarbfi:2009-03

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Postal: The Aarhus School of Business, Fuglesangs Allé 4, DK-8210 Aarhus V, Denmark
Fax: + 45 86 15 19 43
Web page: http://www.asb.dk/about/departments/bs.aspx
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Keywords: monetary policy; large cross-sections; factor-augmented vector autoregression; EM algorithm; state space;

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Cited by:
  1. Lasse BORK & Hans DEWACHTER & Romain HOUSSA, 2009. "Identification of macroeconomic factors in large panels," Center for Economic Studies - Discussion papers ces09.18, Katholieke Universiteit Leuven, Centrum voor Economische Studiën.
  2. Andrés Felipe Londoño & Jorge Andrés Tamayo & Carlos Alberto Velásquez, 2012. "Dinámica de la política monetaria e inflación objetivo en Colombia: una aproximación FAVAR," ENSAYOS SOBRE POLÍTICA ECONÓMICA, BANCO DE LA REPÚBLICA - ESPE.
  3. Kemal Bagzibagli, 2012. "Monetary Transmission Mechanism and Time Variation in the Euro Area," Discussion Papers 12-12, Department of Economics, University of Birmingham.

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