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Opening the Black Box: Structural Factor Models versus Structural VARs

  • Forni, Mario
  • Lippi, Marco
  • Reichlin, Lucrezia

In this Paper we study identification in dynamic factor models and argue that factor models are better suited than VARs to provide a structural representation of the macroeconomy. Factor models distinguish measurement errors and other idiosyncratic disturbances from structural macroeconomic shocks. As a consequence, the number of structural shocks is no longer equal to the number of variables included in the information set. In practice, the number of structural shocks turns out to be small, so that only a few restrictions are needed to reach identification. Economic interpretation is then easier. On the other hand, with factor models we can handle much larger information sets - including virtually all existing macroeconomic information. This solves the problems of superior information and fundamentality and enables us to analyse the effects of the shocks on all macroeconomic variables. In the empirical illustration we study a set of 89 US macroeconomic time series, including the series analysed in the seminal paper of King et al. (1991). We find that the system of impulse response functions of these series is non-fundamental and therefore cannot be estimated with a VAR. Moreover, unlike in King et al. (1991), the impulse response functions of the permanent shock are monotonic and therefore more credible if the permanent shock is interpreted as technical change.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4133.

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Date of creation: Dec 2003
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Handle: RePEc:cpr:ceprdp:4133
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  1. Forni, Mario & Hallin, Marc & Lippi, Marco & Reichlin, Lucrezia, 2002. "The Generalized Dynamic Factor Model: One-Sided Estimation and Forecasting," CEPR Discussion Papers 3432, C.E.P.R. Discussion Papers.
  2. Chamberlain, Gary & Rothschild, Michael, 1983. "Arbitrage, Factor Structure, and Mean-Variance Analysis on Large Asset Markets," Econometrica, Econometric Society, vol. 51(5), pages 1281-304, September.
  3. Giannone, Domenico & Reichlin, Lucrezia & Sala, Luca, 2002. "VARs, Common Factors and the Empirical Validation of Equilibrium Business Cycle Models," CEPR Discussion Papers 3701, C.E.P.R. Discussion Papers.
  4. Sims, Christopher A, 1998. "Comment on Glenn Rudebusch's "Do Measures of Monetary Policy in a VAR Make Sense?"," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 933-41, November.
  5. Robert G. King & Charles I. Plosser & James H. Stock & Mark W. Watson, 1991. "Stochastic trends and economic fluctuations," Working Paper Series, Macroeconomic Issues 91-4, Federal Reserve Bank of Chicago.
  6. Jushan Bai & Serena Ng, 2000. "Determining the Number of Factors in Approximate Factor Models," Econometric Society World Congress 2000 Contributed Papers 1504, Econometric Society.
  7. Mario Forni & Lucrezia Reichlin, 2001. "Federal policies and local economies: Europe and the U.S," ULB Institutional Repository 2013/10141, ULB -- Universite Libre de Bruxelles.
  8. Stock, James H & Watson, Mark W, 2002. "Macroeconomic Forecasting Using Diffusion Indexes," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(2), pages 147-62, April.
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  10. Forni, Mario & Reichlin, Lucrezia, 1996. "Dynamic Common Factors in Large Cross-Sections," Empirical Economics, Springer, vol. 21(1), pages 27-42.
  11. Forni, Mario & Reichlin, Lucrezia, 1998. "Let's Get Real: A Factor Analytical Approach to Disaggregated Business Cycle Dynamics," Review of Economic Studies, Wiley Blackwell, vol. 65(3), pages 453-73, July.
  12. Marco Lippi & Lucrezia Reichlin, 1993. "The dynamic effects of aggregate demand and supply disturbances: comment," ULB Institutional Repository 2013/10159, ULB -- Universite Libre de Bruxelles.
  13. Jon Faust, 1998. "The robustness of identified VAR conclusions about money," International Finance Discussion Papers 610, Board of Governors of the Federal Reserve System (U.S.).
  14. Marco Lippi & Lucrezia Reichlin, 1994. "VAR analysis, non-fundamental representations, Blashke matrices," ULB Institutional Repository 2013/10151, ULB -- Universite Libre de Bruxelles.
  15. Mario Forni & Marc Hallin & Marco Lippi & Lucrezia Reichlin, 2000. "The Generalized Dynamic-Factor Model: Identification And Estimation," The Review of Economics and Statistics, MIT Press, vol. 82(4), pages 540-554, November.
  16. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1998. "Monetary Policy Shocks: What Have We Learned and to What End?," NBER Working Papers 6400, National Bureau of Economic Research, Inc.
  17. Thomas J. Sargent & Christopher A. Sims, 1977. "Business cycle modeling without pretending to have too much a priori economic theory," Working Papers 55, Federal Reserve Bank of Minneapolis.
  18. Eric M. Leeper & Christopher A. Sims & Tao Zha, 1996. "What Does Monetary Policy Do?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(2), pages 1-78.
  19. John H. Cochrane, 1995. "What do the VARs Mean?: Measuring the Output Effects of Monetary Policy," NBER Working Papers 5154, National Bureau of Economic Research, Inc.
  20. Lucrezia Reichlin & Mario Forni & Marc Hallin & Marco Lippi, 2001. "Coincident and leading indicators for the Euro area," ULB Institutional Repository 2013/10137, ULB -- Universite Libre de Bruxelles.
  21. Mario Forni & Marc Hallin & Marco Lippi & Lucrezia Reichlin, 2004. "The generalised dynamic factor model: consistency and rates," ULB Institutional Repository 2013/10133, ULB -- Universite Libre de Bruxelles.
  22. Uhlig, Harald, 2005. "What are the effects of monetary policy on output? Results from an agnostic identification procedure," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 381-419, March.
  23. Lutz Kilian, 1998. "Small-Sample Confidence Intervals For Impulse Response Functions," The Review of Economics and Statistics, MIT Press, vol. 80(2), pages 218-230, May.
  24. Forni, Mario & Lippi, Marco, 2000. "The Generalized Dynamic Factor Model: Representation Theory," CEPR Discussion Papers 2509, C.E.P.R. Discussion Papers.
  25. Faust, Jon, 1998. "The robustness of identified VAR conclusions about money," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 49(1), pages 207-244, December.
  26. Stock J.H. & Watson M.W., 2002. "Forecasting Using Principal Components From a Large Number of Predictors," Journal of the American Statistical Association, American Statistical Association, vol. 97, pages 1167-1179, December.
  27. James H. Stock & Mark W. Watson, 2001. "Vector Autoregressions," Journal of Economic Perspectives, American Economic Association, vol. 15(4), pages 101-115, Fall.
  28. Granger, C. W. J., 1987. "Implications of Aggregation with Common Factors," Econometric Theory, Cambridge University Press, vol. 3(02), pages 208-222, April.
  29. Gamber, Edward N & Joutz, Frederick L, 1993. "The Dynamic Effects of Aggregate Demand and Supply Disturbances: Comment," American Economic Review, American Economic Association, vol. 83(5), pages 1387-93, December.
  30. Forni, Mario & Lippi, Marco, 1997. "Aggregation and the Microfoundations of Dynamic Macroeconomics," OUP Catalogue, Oxford University Press, number 9780198288008, March.
  31. Connor, Gregory & Korajczyk, Robert A., 1988. "Risk and return in an equilibrium APT : Application of a new test methodology," Journal of Financial Economics, Elsevier, vol. 21(2), pages 255-289, September.
  32. Giannone, Domenico & Reichlin, Lucrezia & Sala, Luca, 2002. "Tracking Greenspan: Systematic and Unsystematic Monetary Policy Revisited," CEPR Discussion Papers 3550, C.E.P.R. Discussion Papers.
  33. James H. Stock & Mark W. Watson, 1998. "Diffusion Indexes," NBER Working Papers 6702, National Bureau of Economic Research, Inc.
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