Econometric Analysis of Structural Systems with Permanent and Transitory Shocks

Abstract

This paper considers the implications of the permanent/transitory decomposition of shocks for identification of structural models in the general case where the model might contain more than one permanent structural shock. It provides a simple and intuitive generalization of the influential work of Blanchard and Quah (1989), and shows that structural equations with known permanent shocks can not contain error correction terms, thereby freeing up the latter to be used as instruments in estimating their parameters. The approach is illustrated by a re-examination of the identification schemes used by Wickens and Motto (2001), Shapiro and Watson (1988), King, Plosser, Stock, Watson (1991), Gali (1992, 1999) and Fisher (2006).

Keywords: Permanent shocks, structural identification, error correction

JEL Classification: C30, C32, E10