Econometric Issues when Modelling with a Mixture of I(1) and I(0) Variables
This paper considers structural models when both I(1) and I(0) variables are present. It is necessary to extend the traditional classification of shocks as permanent and transitory, and we do this by introducing a mixed shock. The extra shocks coming from introducing I(0) variables into a system are then classified as either mixed or transitory. Conditions are derived upon the nature of the SVAR in the event that these extra shocks are transitory. We then analyse what happens when there are mixed shocks, finding that it changes a number of ideas that have become established from the cointegration literature. The ideas are illustrated using a well-known SVAR where there are mixed shocks. This SVAR is re-formulated so that the extra shocks coming from the introduction of I(0) variables do not affect relative prices in the long-run and it is found that this has major implications for whether there is a price puzzle. It is also shown how to handle long-run parametric restrictions when some shocks are identified using sign restrictions.
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