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Theory coherent shrinkage of Time-Varying Parameters in VARs

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  • Andrea Renzetti

Abstract

Time-Varying Parameters Vector Autoregressive (TVP-VAR) models are frequently used in economics to capture evolving relationships among the macroeconomic variables. However, TVP-VARs have the tendency of overfitting the data, resulting in inaccurate forecasts and imprecise estimates of typical objects of interests such as the impulse response functions. This paper introduces a Theory Coherent Time-Varying Parameters Vector Autoregressive Model (TC-TVP-VAR), which leverages on an arbitrary theoretical framework derived by an underlying economic theory to form a prior for the time varying parameters. This "theory coherent" shrinkage prior significantly improves inference precision and forecast accuracy over the standard TVP-VAR. Furthermore, the TC-TVP-VAR can be used to perform indirect posterior inference on the deep parameters of the underlying economic theory. The paper reveals that using the classical 3-equation New Keynesian block to form a prior for the TVP- VAR substantially enhances forecast accuracy of output growth and of the inflation rate in a standard model of monetary policy. Additionally, the paper shows that the TC-TVP-VAR can be used to address the inferential challenges during the Zero Lower Bound period.

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  • Andrea Renzetti, 2023. "Theory coherent shrinkage of Time-Varying Parameters in VARs," Papers 2311.11858, arXiv.org.
    • Handle: RePEc:arx:papers:2311.11858
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    References listed on IDEAS

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    1. Andrea Carriero & Todd E. Clark & Massimiliano Marcellino, 2021. "No‐arbitrage priors, drifting volatilities, and the term structure of interest rates," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 36(5), pages 495-516, August.
    2. Niko Hauzenberger & Florian Huber & Massimiliano Marcellino & Nico Petz, 2021. "Gaussian Process Vector Autoregressions and Macroeconomic Uncertainty," Papers 2112.01995, arXiv.org, revised Nov 2022.
    3. Adam Cagliarini & Mariano Kulish, 2013. "Solving Linear Rational Expectations Models with Predictable Structural Changes," The Review of Economics and Statistics, MIT Press, vol. 95(1), pages 328-336, March.
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