Innovation Accounting with Incomplete Identification of a Structural VAR – An Application to Exchange Rates

16 Pages Posted: 1 Oct 2012

Date Written: September 30, 2012

Abstract

Two main objectives of Structural Vector AutoRegression (SVAR) modeling are recovering structural shocks from reduced form shocks and Impulse-Response Analysis and Forecast error variance decomposition. As is well known, the first of these is possible only if the number of structural shocks is less than or equal to the number of endogenous VAR variables. The main goal of this paper is to highlight that the second objective can be accomplished even if the number of structural shocks is greater than the number of VAR variables. As an illustration, a bivariate SVAR is developed to relate the joint dynamics of real and nominal exchange rates to three structural shocks, namely, demand, supply and nominal shocks. Variance decomposition results suggest that demand shocks are the dominant source of movements in both the real and nominal exchange rates. However, nominal shocks also appear to play a smaller but still important role. Interestingly, the persistence of exchange rates appears to be related mainly to nominal and supply shocks.

Keywords: structural VAR, identification, exchange rates, real shocks, monetary shocks

JEL Classification: C32, F31

Suggested Citation

Rao, Vadhindran K., Innovation Accounting with Incomplete Identification of a Structural VAR – An Application to Exchange Rates (September 30, 2012). Available at SSRN: https://ssrn.com/abstract=2154775 or http://dx.doi.org/10.2139/ssrn.2154775

Vadhindran K. Rao (Contact Author)

Metropolitan State University ( email )

700 East Seventh Street
St. Paul, MN 55106
United States

HOME PAGE: http://www.metrostate.edu

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