A Lucas Critique Compliant SVAR model with Observation-driven Time-varying Parameters

TL;DR

This paper introduces an observation-driven SVAR model that aligns with the Lucas Critique by allowing structural shocks to influence both macro variables and model parameters, enabling better policy analysis.

Contribution

It presents a novel observation-driven time-varying SVAR model where parameters evolve based on realized shocks, improving upon existing stochastic approaches.

Findings

Parameters driven by realized shocks enhance interpretability.

Model allows simulation of policy interventions.

Aligns with Lucas Critique principles.

Abstract

We propose an observation-driven time-varying SVAR model where, in agreement with the Lucas Critique, structural shocks drive both the evolution of the macro variables and the dynamics of the VAR parameters. Contrary to existing approaches where parameters follow a stochastic process with random and exogenous shocks, our observation-driven specification allows the evolution of the parameters to be driven by realized past structural shocks, thus opening the possibility to gauge the impact of observed shocks and hypothetical policy interventions on the future evolution of the economic system.