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Vector Autoregression Analysis and the Great Moderation

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  • Luca Benati and Paolo Surico

Abstract

Most analyses of the U.S. Great Moderation have been based on VAR methods, and have consistently pointed toward good luck as the main explanation for the greater macroeconomic stability of recent years. Using data generated by a New-Keynesian model in which the only source of change is the move from passive to active monetary policy, we show that VARs may misinterpret good policy for good luck. In particular, we detect significant breaks in estimated VAR innovation variances, although in the data generating process the volatilities of the structural shocks are constant across policy regimes. Counterfactual simulations, structural and reduced-form, point toward the incorrect conclusion of good luck. Our results cast doubts on the existing notion that VAR evidence is inconsistent with the good policy explanation of the Great Moderation.

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Bibliographic Info

Paper provided by Monetary Policy Committee Unit, Bank of England in its series Discussion Papers with number 18.

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Date of creation: 2007
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Handle: RePEc:mpc:wpaper:18

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  1. Fabio Canova & Luca Gambetti, 2003. "Structural changes in the US economy: is there a role for monetary policy?," Economics Working Papers 918, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 2008.
  2. Gabriel Perez-Quiros & Margaret M. McConnell, 2000. "Output Fluctuations in the United States: What Has Changed since the Early 1980's?," American Economic Review, American Economic Association, vol. 90(5), pages 1464-1476, December.
  3. Troy Davig & Eric M. Leeper, 2005. "Generalizing the Taylor Principle," NBER Working Papers 11874, National Bureau of Economic Research, Inc.
  4. Canova, Fabio & Gambetti, Luca & Pappa, Evi, 2006. "The Structural Dynamics of US Output and Inflation: What Explains the Changes?," CEPR Discussion Papers 5879, C.E.P.R. Discussion Papers.
  5. Frank Smets & Rafael Wouters, 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," American Economic Review, American Economic Association, vol. 97(3), pages 586-606, June.
  6. James H. Stock & Mark W. Watson, 2002. "Has the Business Cycle Changed and Why?," NBER Working Papers 9127, National Bureau of Economic Research, Inc.
  7. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
  8. Edward Nelson & Kalin Nikolov, 2002. "Monetary policy and stagflation in the UK," Bank of England working papers 155, Bank of England.
  9. Christopher A. Sims & Tao Zha, 2005. "Were There Regime Switches in U.S. Monetary Policy?," Working Papers 92, Princeton University, Department of Economics, Center for Economic Policy Studies..
  10. Christina D. Romer & David H. Romer, 2002. "The Evolution of Economic Understanding and Postwar Stabilization Policy," NBER Working Papers 9274, National Bureau of Economic Research, Inc.
  11. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  12. Diebold, Francis X. & Chen, Celia, 1996. "Testing structural stability with endogenous breakpoint A size comparison of analytic and bootstrap procedures," Journal of Econometrics, Elsevier, vol. 70(1), pages 221-241, January.
  13. Lubik, Thomas A. & Schorfheide, Frank, 2003. "Computing sunspot equilibria in linear rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 28(2), pages 273-285, November.
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Cited by:
  1. Francesco Bianchi & Haroon Mumtaz, 2010. "Dynamics of the Term Structure of UK Interest Rates," Working Papers 10-38, Duke University, Department of Economics.
  2. Erdemlioglu, Deniz M & Xiao, Wei, 2008. "Indeterminate Equilibria in New Keynesian DSGE Model: An Application to the US Great Moderation," MPRA Paper 10322, University Library of Munich, Germany.

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