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Theory coherent shrinkage of Time-Varying Parameters in VARs

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  • Andrea Renzetti

Abstract

This paper introduces a novel theory-coherent shrinkage prior for Time-Varying Parameter VARs (TVP-VARs). The prior centers the time-varying parameters on a path implied a priori by an underlying economic theory, chosen to describe the dynamics of the macroeconomic variables in the system. Leveraging information from conventional economic theory using this prior significantly improves inference precision and forecast accuracy compared to the standard TVP-VAR. In an application, I use this prior to incorporate information from a New Keynesian model that includes both the Zero Lower Bound (ZLB) and forward guidance into a medium-scale TVP-VAR model. This approach leads to more precise estimates of the impulse response functions, revealing a distinct propagation of risk premium shocks inside and outside the ZLB in US data.

Suggested Citation

  • Andrea Renzetti, 2023. "Theory coherent shrinkage of Time-Varying Parameters in VARs," Papers 2311.11858, arXiv.org, revised Nov 2024.
    • Handle: RePEc:arx:papers:2311.11858
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    1. Guido Ascari & Paolo Bonomolo & Qazi Haque, 2023. "The Long-Run Phillips Curve is ... a Curve," Working Papers 789, DNB.
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    4. 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.
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