Working Paper: CEPR ID: DP4133
Authors: Mario Forni; Marco Lippi; Lucrezia Reichlin
Abstract: 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.
Keywords: Dynamic Factor Models; Identification; Structural VARs
JEL Codes: C10; E00
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| dynamic factor models (C22) | identification of structural macroeconomic shocks (E00) |
| separation of measurement errors from true shocks (C22) | identification of structural macroeconomic shocks (E00) |
| smaller number of structural shocks (E32) | effective representation of the macroeconomy (E13) |
| impulse response functions from factor models (C22) | credibility of results (C90) |
| nonfundamental impulse response functions in VARs (C32) | implausible negative slopes (C29) |
| permanent shock (Y50) | monotonic effect on output (C29) |
| permanent shock (Y50) | dominant source of business cycle fluctuations (E32) |