Local projections identify the same policy counterfactuals as empirical and structural models

TL;DR

This paper introduces a local projection method to identify policy counterfactuals, showing they align with empirical and structural models under certain conditions, and applies it to oil shocks and interest rate policies.

Contribution

It develops a novel local projection identification approach for policy counterfactuals that matches outcomes from existing models under specific assumptions.

Findings

Local projections match empirical and structural model outcomes under policy invariance.

The method quantifies propagation of oil-supply shocks and interest rate path effects.

Applications include analyzing post-pandemic monetary policy adjustments.

Abstract

We study policy counterfactuals that impose path restrictions on a policy instrument over a finite window. Under a sequential intervention design, we define two counterfactual objects, policy-peg impulse responses and policy-path effects, and we provide a novel local projection identification method. Under policy invariance and a linear moving average envelope, the local projection estimands coincide with the counterfactual outcomes implied by empirical vector autoregressions and linearized forward looking structural models, and the counterfactual outcomes are fully characterized by the relevant impulse responses. We also provide local projection identification of both counterfactual objects under an one-shot intervention design. In the empirical applications, we quantify the propagation of an oil-supply news shock under interest-rate pegs and study alternative liftoff paths during the post-pandemic tightening episode.