Working Paper: CEPR ID: DP9796
Authors: Jonas E. Arias; Juan Francisco Rubio-Ramirez; Daniel F. Waggoner
Abstract: Are optimism shocks an important source of business cycle fluctuations? Are deficit-financed tax cuts better than deficit-financed spending to increase output? These questions have been previously studied using SVARs identified with sign and zero restrictions and the answers have been positive and definite in both cases. While the identification of SVARs with sign and zero restrictions is theoretically attractive because it allows the researcher to remain agnostic with respect to the responses of the key variables of interest, we show that current implementation of these techniques does not respect the agnosticism of the theory. These algorithms impose additional sign restrictions on variables that are seemingly unrestricted that bias the results and produce misleading confidence intervals. We provide an alternative and efficient algorithm that does not introduce any additional sign restriction, hence preserving the agnosticism of the theory. Without the additional restrictions, it is hard to support the claim that either optimism shocks are an important source of business cycle fluctuations or deficit-financed tax cuts work best at improving output. Our algorithm is not only correct but also faster than current ones.
Keywords: Fiscal shocks; Optimism; Sign and zero restrictions; SVARs
JEL Codes: C10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Conditionally agnostic priors (D80) | identification that is influenced by the prior (D91) |
| Using the penalty function approach (PFA) (C51) | optimism shocks significantly influence consumption and hours worked (E71) |
| Optimism shocks (E32) | increased consumption and hours worked (J29) |
| Failing to use conditionally agnostic priors (D80) | conclusions drawn in previous literature may be overstated (D15) |
| Using conditionally agnostic priors (C11) | identified optimism shocks do not lead to increased consumption and hours worked (E21) |
| Non-agnostic priors (C11) | distort the identification of structural relationships in the model (C51) |