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News, Non-Invertibility, and Structural VARs

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  • Eric R. Sims

    ()
    (Department of Economics, University of Notre Dame)

Abstract

A state space representation of a linearized DSGE model implies a VAR in terms of observable variables. The model is said be non-invertible if there exists no linear rotation of the VAR innovations which can recover the economic shocks. Non-invertibility arises when the observed variables fail to perfectly reveal the state variables of the model. The imperfect observation of the state drives a wedge between the VAR innovations and the deep shocks, potentially invalidating conclusions drawn from structural impulse response analysis in the VAR. The principal contribution of this paper is to show that non-invertibility should not be thought of as an ``either/or'' proposition even when a model has a non-invertibility, the wedge between VAR innovations and economic shocks may be small, and structural VARs may nonetheless perform reliably. As an increasingly popular example, so-called ``news shocks'' generate foresight about changes in future fundamentals such as productivity, taxes, or government spending and lead to an unassailable missing state variable problem and hence non-invertible VAR representatations. Simulation evidence from a medium scale DSGE model augmented with news shocks about future productivity reveals that structural VAR methods often perform well in practice, in spite of a known non-invertibility. Impulse responses obtained from VARs closely correspond to the theoretical responses from the model, and the estimated VAR responses are successful in discriminating between alternative, nested specifications of the underlying DSGE model. Since the non-invertibility problem is, at its core, one of missing information, conditioning on more information, for example through factor augmented VARs, is shown to either ameliorate oreliminate invertibility problems altogether.

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File URL: http://www3.nd.edu/~tjohns20/RePEc/deendus/wpaper/013_vars.pdf
File Function: First version, 2012
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Bibliographic Info

Paper provided by University of Notre Dame, Department of Economics in its series Working Papers with number 013.

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Length: 50 pages
Date of creation: Jun 2012
Date of revision: Jun 2012
Handle: RePEc:nod:wpaper:013

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Keywords: DSGE; VAR; News shocks;

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Cited by:
  1. Massimo Franchi, 2013. "Comment on: Ravenna, F., 2007. Vector autoregressions and reduced form representations of DSGE models. Journal of Monetary Economics 54, 2048-2064," DSS Empirical Economics and Econometrics Working Papers Series 2013/2, Centre for Empirical Economics and Econometrics, Department of Statistics, "Sapienza" University of Rome.
  2. Canova, Fabio & Ciccarelli, Matteo, 2013. "Panel Vector Autoregressive Models: A Survey," CEPR Discussion Papers 9380, C.E.P.R. Discussion Papers.
  3. repec:car:carecp:13-10 is not listed on IDEAS
  4. Féve, Patrick & Jidoud, Ahmat, 2012. "Identifying News Shocks from SVARs," Journal of Macroeconomics, Elsevier, vol. 34(4), pages 919-932.
  5. Saleem Bahaj, 2014. "Systemic Sovereign Risk: Macroeconomic Implications in the Euro Area," Discussion Papers 1406, Centre for Macroeconomics (CFM).

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