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Assessing monetary policy in the euro area: a factor-augmented VAR approach

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  • Rita Soares

Abstract

In order to overcome the omitted information problem of small-scale vector autoregression (VAR) models, this study combines the VAR methodology with dynamic factor analysis and assesses the effects of monetary policy shocks in the euro area in the period during which there is a single monetary policy. Using the factor-augmented vector auto-regressive (FAVAR) approach of Bernanke et al. (2005), we summarise the information contained in a large set of macroeconomic time series with a small number of estimated factors and use them as regressors in recursive VARs to evaluate the impact of the non-systematic component of the ECB’s actions. Overall, our results suggest that the inclusion of factors in the VAR allows us to obtain a more coherent picture of the effects of monetary policy innovations, both by achieving responses easier to understand from the theoretical point of view and by increasing the precision of such responses. Moreover, this framework allows us to compute impulse-response functions for all the variables included in the panel, thereby providing a more complete and accurate depiction of the effects of policy disturbances. However, the extra information generated by the FAVAR also delivers some puzzling responses, in particular those relating to exchange rates.

Suggested Citation

  • Rita Soares, 2011. "Assessing monetary policy in the euro area: a factor-augmented VAR approach," Working Papers w201111, Banco de Portugal, Economics and Research Department.
  • Handle: RePEc:ptu:wpaper:w201111
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    File URL: https://www.bportugal.pt/sites/default/files/anexos/papers/wp201111.pdf
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    References listed on IDEAS

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    1. Gianluca Lagana & Andrew Mountford, 2005. "Measuring Monetary Policy In The Uk: A Factor-Augmented Vector Autoregression Model Approach," Manchester School, University of Manchester, vol. 73(s1), pages 77-98, September.
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    Cited by:

    1. von Borstel, Julia & Eickmeier, Sandra & Krippner, Leo, 2016. "The interest rate pass-through in the euro area during the sovereign debt crisis," Journal of International Money and Finance, Elsevier, vol. 68(C), pages 386-402.

    More about this item

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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