Opening the Black Box: Structural Factor Models Versus Structural Vars

29 Pages Posted: 18 Dec 2003

See all articles by Mario Forni

Mario Forni

Università degli studi di Modena e Reggio Emilia (UNIMORE) - Faculty of Business and Economics; Centre for Economic Policy Research (CEPR)

Marco Lippi

Dipartimento di Scienze Economiche (DiSSE); Einaudi Institute for Economics and Finance (EIEF)

Lucrezia Reichlin

London Business School; Université Libre de Bruxelles (ULB) - European Center for Advanced Research in Economics and Statistics (ECARES); Centre for Economic Policy Research (CEPR); European Central Bank (ECB)

Date Written: December 2003

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, structural VARs, identification

JEL Classification: C10, E00

Suggested Citation

Forni, Mario and Lippi, Marco and Reichlin, Lucrezia, Opening the Black Box: Structural Factor Models Versus Structural Vars (December 2003). Available at SSRN: https://ssrn.com/abstract=481222

Mario Forni (Contact Author)

Università degli studi di Modena e Reggio Emilia (UNIMORE) - Faculty of Business and Economics ( email )

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Marco Lippi

Dipartimento di Scienze Economiche (DiSSE) ( email )

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Lucrezia Reichlin

London Business School ( email )

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