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Infinite-dimensional VARs and factor models

  • Chudik, Alexander
  • Pesaran, Hashem

This paper introduces a novel approach for dealing with the 'curse of dimensionality' in the case of large linear dynamic systems. Restrictions on the coefficients of an unrestricted VAR are proposed that are binding only in a limit as the number of endogenous variables tends to infinity. It is shown that under such restrictions, an infinite-dimensional VAR (or IVAR) can be arbitrarily well characterized by a large number of finite-dimensional models in the spirit of the global VAR model proposed in Pesaran et al. (JBES, 2004). The paper also considers IVAR models with dominant individual units and shows that this will lead to a dynamic factor model with the dominant unit acting as the factor. The problems of estimation and inference in a stationary IVAR with unknown number of unobserved common factors are also investigated. A cross section augmented least squares estimator is proposed and its asymptotic distribution is derived. Satisfactory small sample properties are documented by Monte Carlo experiments. JEL Classification: C10, C33, C51

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Paper provided by European Central Bank in its series Working Paper Series with number 0998.

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Date of creation: Jan 2009
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Handle: RePEc:ecb:ecbwps:20090998
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  1. Ben S. Bernanke & Jean Boivin & Piotr Eliasz, 2004. "Measuring the effects of monetary policy: a factor-augmented vector autoregressive (FAVAR) approach," Finance and Economics Discussion Series 2004-03, Board of Governors of the Federal Reserve System (U.S.).
  2. Dees, S. & di Mauro, F. & Pesaran, M.H. & Smith, L.V., 2005. "Exploring the International Linkages of the Euro Area: a Global VAR Analysis," Cambridge Working Papers in Economics 0518, Faculty of Economics, University of Cambridge.
  3. M. Hashem Pesaran & Ron Smith, 2006. "Macroeconometric Modelling with a Global Perspective," IEPR Working Papers 06.43, Institute of Economic Policy Research (IEPR).
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