Robust Impulse Responses using External Instruments: the Role of Information

TL;DR

This paper introduces Proxy DFM, a new method for identifying impulse responses in structural models with measurement error, demonstrating its superiority over Proxy SVAR through simulations and US monetary policy analysis.

Contribution

The paper proposes Proxy DFM, a novel identification approach that reliably retrieves true impulse responses in the presence of measurement error and model misspecification.

Findings

Proxy DFM accurately recovers true impulse responses in simulations.

Proxy SVAR fails under model misspecification and measurement error.

US monetary policy shocks are contractionary across multiple economic indicators.

Abstract

External-instrument identification leads to biased responses when the shock is not invertible and the measurement error is present. We propose to use this identification strategy in a structural Dynamic Factor Model, which we call Proxy DFM. In a simulation analysis, we show that the Proxy DFM always successfully retrieves the true impulse responses, while the Proxy SVAR systematically fails to do so when the model is either misspecified, does not include all relevant information, or the measurement error is present. In an application to US monetary policy, the Proxy DFM shows that a tightening shock is unequivocally contractionary, with deteriorations in domestic demand, labor, credit, housing, exchange, and financial markets. This holds true for all raw instruments available in the literature. The variance decomposition analysis highlights the importance of monetary policy shocks in explaining economic fluctuations, albeit at different horizons.