Measuring the Effects of a Shock to Monetary Policy - Humboldt ...

8 Bayesian FAVARs with Agnostic Identification
ambiguously 2 3 . In the current literature there are also approaches to consider an index
extracted with dynamic factor models, representing the relevant dynamics out of many
macroeconomic variables associated with ”economic activity”, such as Korenok and Rad-
chenko [2004]. The consensus seems to be consistent with the ”monetary neutrality” that
monetary policy shocks only affect the nominal but not the real sector in the long-run.
Contrariwise Canova and De Nicolo [2002] show that monetary policy had a significant
effect in reducing the output in the G7 industry countries, hence they implicitly disagree
with the ambiguous effects of monetary policy shocks mentioned by the papers above. The
contentious issue raising the overall dissentation is rather the quantitative magnitude of
the reaction 4 instead of its mere direction. There are methods required to address such
issues quantitatively, which is important for central bankers who have to decide how to
react to the state of the economy. In order to accomplish a sound decision, the monetary
authorities have to be certain about the precise reaction of the economy. For example
in a recession, it might be required to know about the accurate effects, in order to avoid
a policy decision that might rather be a drag on the recovery. The broader the relevant
information set the more accurate is analysis the for central bankers.
The ”workhorse” in applied empirical macroeconomics for accomplishing the question
at hand is the structural vector autoregression (Hence forth SVAR). The problem is that
the VAR framework with its limitations such as the ”curse of dimensionality” 5 cannot
mirror the reality of central bankers decision making, particularly w.r.t. the amount of
information exploited which apparently is relevant for the economy. This might be very
important for researchers because there is little hope that economists can evaluate al-
ternative theories of the monetary policy transmission mechanism, or obtain quantitative
2 See Uhlig [2005]
3 Some researchers measure the effects on output, some rather on industrial output as a representative
”proxy” or ”index” for economic activity (see Sims).
4 In my thesis I only consider the effects of contractionary monetary policy shocks.
5 This was raised by Sims (1980), where he states that with increasing number of variables included in
the VAR, the parameters to be estimated increase quadratically and soon become intractable.