Introduction to modelling

VARs and monetary policy exercise

Our data is contained in the Excel spreadsheet US and Canada.xls. The spreadsheet comprises, among
others, the following data series for Canada (denoted by _CN) and the US (denoted by _US):1

base rates (BR_CN and BR_US);

the three-month Canadian Treasury Bill interest rate (TREASURYB_CN);
an average 3-5-year Canadian government bond yield (GOVY_CN);
nominal Canadian M1, M2 and M3 (M1_CN, M2_CN and M3_CN);
consumer price indices (CPI_CN and CPI_US);
GDP deflators (GDPDEF_CN and GDPDEF_US);
real GDPs (RGDP_CN and RGDP_US);
real Canadian gross fixed capital formation (RINV_CN);
nominal and effective exchange rates (NOM_EER_CN and NOM_EER_US as well as
RE_CN and RE_US);
the volume of Canadian exports and imports (X_CN and IM_CN);
the Canadian unemployment rate (UN_CN); and
a commodity price index (PCM)

We constructed other series, such as inflation (INF_CN and INF_US), the interest-rate differential
between Canada and the US (BR_CN_US), the exchange rate depreciation (DPN_CN and DPN_US),
the output gap using the Hodrick-Prescott filter (GDP_GAP_CN and GDP_GAP_US) and the annual
growth rate of (real) GDP (DGDP4_CN and DGDP4_US). Variables that start with an L denote the
natural logarithm of the series.
The data are quarterly and span the period from 1950 Q1 to 2005 Q2, although not all series are
available for such a long period. Recall from the presentation that it is important to estimate parameters
in structural VARs by concentrating on a single policy regime. Any regime shift requires a different
parameterisations. This important caveat may explain some of the counterintuitive results we may
encounter in the following exercise.2 The main justification for this practice is that monetary policy
shocks are deemed to be robust to the different identification schemes generated by the different
monetary policy regimes.
1

Preparations

VAR modelling in JMulTi is meant as a step-by-step procedure, where each task is related to a special
panel. Once a model has been estimated, the diagnostic tests as well as the stability and the structural
analyses use the results from the estimation. If changes in the model specification are made, these
results are deleted and the model has to be re-estimated. In other words, only results related to any one
model at a time are kept in the system. Hence, there should be no confusion regarding the model set-up
while going through the analysis.
Open JMulTi and wait for the programme to load. Of the seven options in the window on the left,
select the second-to-last, VAR Analysis. Go to File, Import Data, change the file type to .xls and open

But we will not be using all the data series in the following analysis.
For example, many SVAR studies of US monetary policy shocks leave out the disinflationary period from 1979 to 1984,
which clearly constitutes a different monetary policy regime.
2

the file US and Canada.xls. The only thing we have to tell JMulTi when loading data is the start of the
sample period, so please enter 1950 Q1 when prompted.
2

Closed-economy estimation of monetary policy shocks

Monetary economics focuses on the behaviour of prices, monetary aggregates, nominal and real interest
rates and output. Vector autoregressions (VARs) have served as a primary tool in much of the
empirical analysis of the interrelationships between those variables and for uncovering the impact of
monetary phenomena on the real economy. A summary of the empirical findings in this literature can
be found in, inter alia, Leeper et al. (1996) and Christiano et al. (1998).
On the basis of extensive empirical VAR analysis, Christiano et al. (1998) derived stylised facts about
the effects of a contractionary monetary policy shock. They concluded that plausible models of the
monetary transmission mechanism should be consistent with at least the following evidence on prices,
output and interest rates. Following a contractionary monetary policy shock:
(i) the aggregate price level initially responds very little;
(ii) interest rates initially rise; and
(iii) aggregate output initially falls, with a J-shaped response, with a zero long-run effect of the
monetary policy shock.
Recall that monetary policy shocks are defined as deviations from the monetary policy rule that are
obtained by considering an exogenous shock which does not alter the response of the monetary policymaker to macroeconomic conditions. VAR models of the effects of monetary policy shocks have
therefore exclusively concentrated on simulating shocks, leaving the systematic component of monetary
policy unaltered.
3

Defining a monetary policy VAR model

It is interesting to see how the specification of the closed-economy benchmark model of monetary
policy shocks has developed over time. In the exercises below, we will broadly follow the historical
development of this model. Initially, such models were estimated (and identified) on a rather limited set
of variables, i.e., prices, output and money, and identified using a diagonal form on the variancecovariance matrix D of the structural shocks and a lower triangular form on the contemporaneous
impact matrix F.
As we will see, there have been significant changes in the empirical analysis since then. First, the
position of the monetary-policy instrument in the ordering of the variables included in the VAR has
been changing over time. Second, the monetary policy instrument is no longer a monetary aggregate.
Most analysis now generally acknowledges that a (short-term) interest rate is the relevant monetarypolicy instrument. Moreover, the nature of the identification restrictions has also changed from
recursive systems to non-recursive schemes that attempt identification on the basis of postulated
economic relationships. Finally, most industrial-country benchmark models of monetary policy now
contain six or seven variables rather than the initial three.
A key consideration before any estimation is the form the variables must have when they enter the
VAR: should they enter in levels, gaps or first differences? The answer is simply it depends. It
depends on what the VAR is going to be used for. For forecasting purposes, we must avoid potential
spurious regressions that may result in spurious forecasts; for the purpose of identifying structural
shocks (such as monetary policy shocks) we have to be careful about the stability of the VAR (i.e.,
whether it can be inverted), the reliability of our impulse response functions and the residuals.
Q1. Before we estimate our model, what could we do to ensure unbiased estimates?
2

Answer: We use OLS to estimate the VARs so if we are interested in forecasting, say, we need to
ensure that all variables are stationary or cointegrated to avoid the spurious regression problem
associated with unit roots.
As shown by Toda and Yamamoto (1995) and Dolado and Ltkepohl (1996), if all variables in the VAR
are either I(0) or I(1) and if a null hypothesis is considered that does not restrict elements of each of the
Ais (i = 1, , p), the usual tests have their standard asymptotic normal disturbances. Moreover, if the
VAR order p 2, the t-ratios have their usual asymptotic standard normal distributions and they remain
suitable statistics for testing the null hypothesis that a single coefficient in one of the parameter matrices
is zero (while leaving the other parameter matrices unrestricted). This alleviates the spurious regression
problem on the use of standard asymptotic normal disturbances.
Given the results in Sims et al. (1990), potential non-stationarity in the VAR under investigation should
not affect the model selection process. Moreover, maximum likelihood estimation procedures may be
applied to a VAR model fitted to the levels even if variables have unit roots; hence, possible
cointegration rejections are ignored. This is frequently done in (S)VAR modelling to avoid imposing
too many restrictions, and we follow this approach here.
3.1

Sims (1980b) model: putting money first

We follow the academic literature that has tried to identify monetary policy shocks. In common with
that literature we use variables in levels (and in logs), see, e.g., Christiano et al. (1998), Favero (2001)
and Leeper et al. (1996).
Q2. Estimate an unrestricted VAR. We start our estimation with LM1_CN, LRGDP_CN and
LCPI_CN, including also a constant. Select the three variables in that order, then confirm your
selection. Remember that selection order sets variable order. The chosen variables in the order in
which they were chosen appear in red in a window at the bottom of the right-hand side. Pressing Max
selects the longest sample period (which should be 1961 Q1 to 2005 Q1 in this case). Note that we will
be measuring the impact of monetary policy by positive shocks to the monetary aggregate, M1, i.e.,
expansionary monetary policy.
The typical identifying assumption in much of Sims earlier work (such as Sims (1980b)) is that the
monetary policy variable is unaffected by contemporaneous innovations in the other variables, that is, it
is put first in the VAR. This approach corresponds to the assumption that the money supply is
predetermined and that policy innovations are exogenous with respect to the non-policy innovations.
This corresponds to a situation in which the policy variable does not respond contemporaneously to
output shocks, perhaps because of information lags in formulating policy.
Q3. What should be the lag length of the VAR?
Adding more lags improves the fit of the estimated model but reduces the degrees of freedom and
increases the danger of over-fitting. An objective way to decide between these competing objectives is
to maximise some weighted measures of these two parameters. This is how the Akaike information
criterion (AIC), the Schwarz Bayesian criterion (SC) and the Hannan-Quinn criterion (HQ) work.
These three statistics are measures of the trade-off of fit against loss of degrees of freedom so that the
best lag length should minimise all of them.3
An alternative to the information criterion is to systematically test for the significance of each lag using
a likelihood-ratio test (discussed in Ltkepohl, 1991, section 4.3). This is the approach favoured by
Sims (1980a). Since a VAR of lag length n nests the same VAR of lag length (n - 1), the log-likelihood
3

Some programs maximise the negative of these measures.

difference multiplied by the number of observations less the number of regressors in the VAR should be
distributed as a 2-squared distribution with 2k degrees of freedom, i.e., 2(2k). In other words,
LR = (T - m) {logn-1 - logn} ~ 2(2k)
where T is the number of observations, m is the number of regressors in each equation of the
unrestricted VAR and logn is the log-likelihood of the VAR with n lags. For each lag length, if
there is no improvement in the fit from the inclusion of the last lag, then the difference in loglikelihoods should not be significantly different from zero. For example, we could use a general-tospecific methodology (some authors follow a specific-to-general approach, instead):
we start with a high lag length (say, 12 lags for quarterly data);4
for each lag, say n, note its log-likelihood and then calculate the log-likelihood for a VAR of
lag (n-1);
(iii) take the difference of the log-likelihoods; and
(iv) this difference should be distributed as a 2-distribution.5
(i)
(ii)

It is important to note that the residuals from the estimated VAR should be well behaved, that is, there
should be no problems with autocorrelation and non-normality. Thus, whilst the AIC or the SC may be
good starting points for determining the lag-length of the VAR, it is still important to check for
autocorrelation. If we find that there is autocorrelation for the chosen lag length, one ought to increase
the lag-length until the problem disappears. Similarly, if there are problems with non-normality, a
useful trick is to add exogenous variables to the VAR (they may correct the problem), including the use
of dummy variables and time trends.
At the same time, we should note that the specification of the monetary policy VAR and its statistical
adequacy is an issue that has not received much explicit attention in the literature. In most of the
applied papers, the lag length is either decided uniformly on an ad hoc basis, several different lag
lengths are estimated for robustness, or the lag length is simply set on the basis of information criteria.
Virtually none of the papers cited in this exercise actually undertake any rigorous assessment of the
statistical adequacy of the estimated models.
Q4. Test for the appropriate number of lags using the AIC, SC, HQ and the final prediction error (FPE)
criteria.
Answer: To select the endogenous lags, it may be helpful to use the information criteria. Set
Endogenous max lags to 12, tick the box for a constant only and press Compute Infocriteria. A
search is performed over the lags of the endogenous variables up to the maximum order. The output
should be:
OPTIMAL ENDOGENOUS LAGS FROM INFORMATION CRITERIA
endogenous variables:
deterministic variables:
sample range:

LM1_CN LRGDP_CN LCPI_CN

CONST
[1964 Q1, 2005 Q1], T = 165

optimal number of lags (searched up to 12 lags of levels):

Akaike Info Criterion:
5
Final Prediction Error:
5
Hannan-Quinn Criterion:
3
4

Obviously, this will depend on the frequency of your data, so that if you have quarterly data you could start with say 10-12
lags, if you have annual data with 2-3 lags and if you have monthly data with 18-24 lags.
5
This depends on the number of variables in the VAR. For our case we have three variables, thus 2*k = 2*3 = 6.

Schwarz Criterion:

The correct lag length will depend on the criteria or measure we use. This is typical of these tests and
researchers often use the criterion most convenient for their needs. The SC criterion is generally more
conservative in terms of lag length than the AIC criterion, i.e., it selects a shorter lag length than the
AIC criterion.
Q5. Does the chosen VAR have appropriate properties?
autocorrelated? Is the VAR stable?

Are the residuals normal and not

In order to carry out tests for these properties, the model will have to be specified and estimated first. A
useful tip is to start with the VAR with the minimum number of lags according to the information
criteria (in this case two lags) and test whether there are problems with autocorrelation and nonnormality. Under Specification, Specify VAR Model, set endogenous lags equal to two and go to the
Estimation panel and select Estimated Model.
In JMulTi, plots of autocorrelations, partial autocorrelations and cross-correlations are found in Model
Checking, Residual Analysis, Correlation. The following three charts show autocorrelations as well
as partial autocorrelations for each of the error series u1, u2 and u3. On several occasions, both u2 and u3
markedly exceed the 2/T bounds. Some of these residual autocorrelations give rise to concern as the
large autocorrelations occur at short lags, especially for u3. We can be more sanguine about residual
autocorrelations reaching outside the 2/T bounds if these violations occur at large lags, as is the
case for u2, say.

Answer: In JMulTi, tests for residual autocorrelation, non-normality and conditional heteroskedasticity
are available for diagnostic checking of estimated VAR models. Having estimated the VAR(2) model,
residual tests can be found under Model Checking, Residual Analysis. Select the tests you want in the
Diagnostic Tests window (in our case, the portmanteau test (with 16 lags), the LM type-test for
6

autocorrelation (with five lags), tests for normality and the univariate ARCH-LM test (with 16 lags))
and press Execute. 6
The portmanteau test checks the null hypothesis H0: E(utut-i) = 0, i = 1, , h (there is no remaining
autocorrelation at lags 1 to h) against the alternative that at least one autocovariance and, hence, one
autocorrelation is non-zero, up to order h. The test may only be applied if the VAR does not contain
exogenous variables. The null hypothesis of no residual autocorrelation is rejected for large values of
the test statistic. An adjusted version of the test statistic may have better small-sample properties:
PORTMANTEAU TEST (H0:Rh=(r1,...,rh)=0)
Reference: Ltkepohl (1993), Introduction to Multiple Time Series
Analysis, 2ed, p. 150.
tested order:
16
test statistic:
185.5839
p-value:
0.0004
adjusted test statistic: 194.8473
p-value:
0.0001
degrees of freedom:
126.0000
Both the original as well as the adjusted test statistic clearly allow us to reject the null hypothesis that all
autocovariances and, hence, all autocorrelations, up to order h are zero, indicating the presence of
autocorrelation.
This is borne out by the Breusch-Godfrey LM test for hth order residual autocorrelation, which assumes
the following underlying AR(h) model of the residuals:
ut = B1ut-1 + + Bhut-h + vt
and tests the null hypothesis that B1 = B2 = = Bh = 0 against the alternative hypothesis that B1 0 or
or Bh 0. The null hypothesis is rejected if LMh is large and exceeds the critical value from the
2(h)-distribution. Again, this test may be biased in small samples and therefore an F-version of the
statistic is given which may perform better (LMFh):
LM-TYPE TEST FOR AUTOCORRELATION with 5 lags
Reference: Doornik (1996), LM test and LMF test (with Fapproximation)
LM statistic:
83.9031
p-value:
0.0004
df:
45.0000
LMF statistic:
1.9648
p-value:
0.0003
df1:
45.0000
df2:
449.0000
Just as in the case of the portmanteau test for autocorrelation, both the original as well as the adjusted
test statistic allow us to reject the null hypothesis that all estimated Bis up to order h are zero, indicating
the presence of autocorrelation. Remaining residual autocorrelation indicates a model defect. It may be
worth trying a VAR model with higher lag orders in that case.
6

The value of h, i.e. the number of autocorrelations included, is obviously important. The size of the test may be unreliable
if h is too small (primarily because the 2-approximation to the null distribution may be very poor), and it may have reduced
power if h is large and, hence, many non-informative autocorrelations are included. For quarterly data, a convenient
benchmark is to set the lag length for the portmanteau test as well as the univariate ARCH-LM test equal to 16 and the lag
order of the multivariate ARCH-LM (if required) as well as the LM tests for autocorrelation equal to 5.

The idea underlying the (multivariate) non-normality tests is to transform the residual vector such that
its components are both standardised and independent and then check the compatibility of the third and
fourth moments, in other words, skewness and kurtosis, with those of a normal distribution (Doornik
and Hansen (1994)). Ltkepohl (1991) proposed an alternative way of computing standardised
residuals, so a test statistic based on his approach is also given.7 Both testing approaches indicate that
there are no problems with non-normality:
TESTS FOR NONNORMALITY
Reference: Doornik & Hansen (1994)
joint test statistic:
5.8910
p-value:
0.4355
degrees of freedom:
6.0000
skewness only:
2.9446
p-value:
0.4002
kurtosis only:
2.9464
p-value:
0.4000
Reference: Ltkepohl (1993), Introduction to Multiple Time Series
Analysis, 2ed, p. 153
joint test statistic:
5.9006
p-value:
0.4344
degrees of freedom:
6.0000
skewness only:
2.8385
p-value:
0.4172
kurtosis only:
3.0621
p-value:
0.3822
JARQUE-BERA TEST
variable
u1
u2
u3

teststat
3.6107
1.2060
0.9640

p-Value(Chi^2) skewness
0.1644
0.2065
0.5472
0.1962
0.6175
-0.0976

kurtosis
3.5697
3.1068
3.3067

Rejection of the null hypothesis of normality may indicate that there are some outlying observations or
that the error process is not homoskedastic.
An ARCH-LM test indicates problems with the series u2 and u3, as the tests statistics associated with
these series are statistically significant, indicating ARCH behaviour in the residual series:
ARCH-LM TEST with 16 lags
variable
u1
u2
u3

teststat
13.2732
49.5994
29.5363

p-Value(Chi^2)
0.6527
0.0000
0.0206

F stat
0.9051
4.5054
2.2672

p-Value(F)
0.5646
0.0000
0.0057

Finally, we can investigate the issue of stability.

Doornik and Hansen (1994) use the square root matrix of the residual covariance matrix, while Ltkepohl (1991) uses the
Choleski decomposition. As is well-known, analysis based on the Choleski decomposition may depend on the ordering of
the variables.

Answer: Since we want to obtain a vector-moving average (VMA) from the VAR, we have to ensure
that our VAR is stable (and thus invertible). It is easy to check for stability in JMulTi. The top portion
of the Output (save/print) window under Estimation shows the modulus of the eigenvalues of the
reverse characteristic polynomial:
modulus of the eigenvalues of the reverse characteristic polynomial:
|z| = (15.1704 4.8395 1.5459 1.0094 1.0656 0.9875)
The last entry is below one in magnitude; thus, this VAR has a problem with stability. In other words, it
cannot be inverted.
In light of the foregoing problems with autocorrelation and instability, we may want to consider adding
more lags as well as deterministic regressors to the estimated VAR model, which would address the
autocorrelation and stability problems respectively.
Adding more lags seems to get rid of the problems with autocorrelation. In particular, having a total of
three lags eliminates the problems with autocorrelation on the basis of the LM-type test but not the
portmanteau test:8
PORTMANTEAU TEST (H0:Rh=(r1,...,rh)=0)
Reference: Ltkepohl (1993), Introduction to Multiple Time Series
Analysis, 2ed, p. 150.
tested order:
16
test statistic:
160.9276
p-value:
0.0044
adjusted test statistic: 169.9171
p-value:
0.0010
degrees of freedom:
117.0000
LM-TYPE TEST FOR AUTOCORRELATION with 5 lags
Reference: Doornik (1996), LM test and LMF test (with Fapproximation)
LM statistic:
58.8265
p-value:
0.0809
df:
45.0000
LMF statistic:
1.2860
p-value:
0.1087
df1:
45.0000
df2:
437.0000
In addition, the residual series are normal using the Doornik and Hansen (1994) test and we cannot
reject the null hypothesis of normality using Ltkepohls (1993) approach:
TESTS FOR NONNORMALITY
Reference: Doornik & Hansen (1994)
joint test statistic:
6.3197
p-value:
0.3884
degrees of freedom:
6.0000
8

This is, unfortunately, a common problem. The response to this quandary is mixed: many researchers pick the test result
that best suits their purposes; others have a favourite test, while others still may continue until they have a test result that is
robust in both tests. Note that simulation results in Hall and McAleer (1989) indicate that the LM test often has higher power
than the portmanteau test.

skewness only:
p-value:
kurtosis only:
p-value:

2.4140
0.4910
3.9057
0.2718

Reference: Ltkepohl (1993), Introduction to Multiple Time Series

Analysis, 2ed, p. 153
joint test statistic:
6.4775
p-value:
0.3719
degrees of freedom:
6.0000
skewness only:
2.4516
p-value:
0.4841
kurtosis only:
4.0259
p-value:
0.2587
But the estimated VAR(3) is still unstable, as can be seen from the second to last modulus of the
eigenvalues of the reverse characteristic polynomial, which is less than one in magnitude:
modulus of the eigenvalues of the reverse characteristic polynomial :
|z| = (2.1527 2.1527 3.3418 1.8351 1.8351 1.2656 1.0746 0.9872
1.0091)
Adding a time trend helps the stability of the VAR (verifying this is left as an exercise).9 Note that
adding a time trend will not always correct instability. Note also that in this case, the inclusion of a
trend fortuitously helps with the Doornik and Hansen (1994) serial correlation test.
It is worth spending a bit of time investigating the individual coefficient estimates. In JMulTi, VAR
output is generated in matrix and text form. The matrix form is a particularly intuitive way of
presenting the estimation results. The matrix panel displays first the endogenous, then the exogenous (if
present) and finally the deterministic regressors. This way of presenting the results reflects the
mathematical notation to make clear what type of model was actually estimated. By right-clicking on
the respective coefficient tables one can increase or decrease the precision of the numbers. By clicking
on the respective buttons, it is possible to display the estimated coefficients, their standard deviations or
their t-statistics.
Even though we estimate a relatively low-dimensioned three-variable VAR with three lags and two
deterministic regressors (a constant and trend) using 174 data points, the model may already be
overparametrised. Using the empirical results on the viability of the usual asymptotic distribution of
test statistics by Toda and Yamamoto (1995) and Dolado and Ltkepohl (1996), we note that just nine
of the 33 estimated parameters are statistically significant at the 5% level:

Although Sims (1980) recommends against the use of a deterministic trend in VAR analysis, we decided not to follow this
advice.

10

3.2

Forecasting VARs in JMulti

While not part of this exercise, we should briefly touch upon forecasting VARs in JMulTi, which is
extremely straightforward as well. Say we are interested in forecasting any (or all) of the variables in
the small three-variable VAR that we have just estimated.
Go to the Forecasting panel and Forecast Variables. We assume that we are interested in (dynamic)
forecasts over a three-year period.10 This would translate into a forecast horizon of 3*4 = 12 quarters.
You will note that the screen changed after entering a forecast horizon of more than one period. This is
because we have to tell JMulTi what the values for the deterministic as well as exogenous regressors
are. In our case, we have two deterministic variables, which are the constant and a linear trend. Indeed,
the forecasted values over the twelve-year period are an invariant value of one for the constant and a
linearly increasing trend. Clicking on one of the three variables will select that variable to forecast,
while clicking on variables while keeping the Ctrl-key pressed down allows for the selection of more
than one variable.

10

Forecasts are based on conditional expectations assuming independent white-noise errors and are computed recursively.

11

Pressing on Forecast generates the required forecast, resulting in text output on the Text (save/print)
tab as well as the following graph:

12

VAR identification

We are now ready to attempt identification of the structural VAR and, by so doing, attempt to identify
monetary policy shocks. In JMulTi, we have an underlying structural equation of the form:
Ayt = C(L)yt + But

(1)

where the structural shocks ut are normally distributed, i.e., ut N(0, I). Unfortunately, we cannot
estimate this equation directly due to identification issues, but instead we have estimated an unrestricted
VAR of the form:
yt = A-1C(L)yt + A-1But

(2)

Matrices A, B and the Cjs are not separately observable. So how can we recover equation (1) from (2)?
The solution is to impose restrictions on our VAR to identify an underlying structure, but what kind of
restrictions are these?
Economic theory can sometimes tell us something about the structure of the system we wish to estimate.
As economists, we must interpret these structural or theoretical assumptions into restrictions on the
VAR. Such restrictions can include, for example:
(i) a causal ordering of shock propagation, e.g., the Choleski decomposition;
(ii) that nominal variables have no long run effect on real variables; and
(iii) the long-run behaviour of variables, e.g., the real exchange rate is constant in the long-run.
13

There are many types of restrictions that can be used to identify the structural VAR. JMulTi allows you
to impose two of them. One type imposes restrictions on the short-run behaviour of the system,
whereas the other type imposes restrictions on the long-run. JMulTi does not allow both types of
restrictions at the same time.
5

Imposing short-run restrictions

To impose short-run restrictions in JMulTi, we use equation (2):

yt = A-1C(L)yt + A-1But
We estimate the random stochastic residual A-1But from the residual t of the estimated VAR:
A-1But = t

(3)

Reformulating equation (3), we have A-1BututB(A-1) = tt, and, since E(utut) = I, we have:
A-1BB(A-1) = E(tt) =

(4)

Equation (4) says that for K variables in yt, the symmetry property of E(tt) imposes K(K + 1)/2
restrictions on the 2K2 unknown elements in A and B. Thus, an additional K(3K - 1)/2 restrictions must
be imposed on A and B to identify the full model. JMulTi requires that such restriction schemes must
be of the form:
At = But

(5)

This is also known as the AB model. In particular, JMulTi offers three versions of the AB model:
(ii) an A model, where B = I (in which case At = ut);
(iii) a B model where A = I (in which case t = But);
(iv) and a general AB model where restrictions can be placed on both matrices.
By imposing structure on matrices A and B, we impose restrictions on the structural VAR in equation
(1). An example of this specification using the Choleski decomposition identification scheme I from
the presentation is:
1

A = a 21
a
31

0
1
a 32

0 , B =
1

b11

0
0

0
b22
0

0
b33

In our example, we have a VAR with three endogenous variables, requiring a total of 12 = 3(3*3 - 1)/2
restrictions. Counting restrictions in the A and B matrices above, we have nine zero restrictions (three
in matrix A and six in matrix B) as well as another three unitary restrictions on the diagonal of matrix A,
giving us the required total of 12 restrictions.
Q6. Impose the Choleski decomposition, which assumes that shocks or innovations are propagated in
the order of LM1_CN, LRGDP_CN and LCPI_CN.
Answer: To impose the restriction above in matrix format, we select SVAR and SVAR Estimation
from the VAR window menu. Then we need to choose between the SVAR AB model or the Blanchard
and Quah long-run-type restriction:
14

The identifying restriction is imposed in terms of the s, which are the residuals from the VAR
estimates, and the us, which are the fundamental or primitive random (stochastic) errors in the
structural system.
To use JMulTis matrix-form restrictions, define the two matrices A and B with the following values:
1 0

A =* 1
* *

0 , B =
1

0
0

0
*
0

0
*

If the AB model is chosen, specify the kind of model you wish to work with (A, B or AB) and impose
the restrictions by clicking on the relevant elements of the matrices activated in the panel. In the most
general case, JMulTi allows you to change all elements in the A matrix as well as the diagonal elements
in the B matrix. Ticking on Edit coefficients manually allows you to enter specific coefficient values.
In order to impose the (lower-triangular) Choleski decomposition, select the Specify general case
option and double-click on the elements below the diagonal in the A matrix until all of them come up
with an asterisk. Executing this setup of the A and B matrices yields the following output:
This is an AB-model
Step 1:
Obtaining starting values from decomposition of correlation matrix...
Iterations needed for correlation matrix decomposition: 11.0000
Vector of rescaled starting values:
-0.0224
0.0060
0.1224
0.0206
0.0074
15

0.0049
Step 2:
Structural VAR Estimation Results
ML Estimation, Scoring Algorithm (see Amisano & Giannini (1992))
Convergence after 1 iterations
Log Likelihood: 2191.8840
Structural VAR is just identified
Estimated A matrix:
1.0000
0.0000
0.0000
-0.0224
1.0000
0.0000
0.0060
0.1224
1.0000
Estimated standard errors for A matrix:
0.0000
0.0000
0.0000
0.0273
0.0000
0.0000
0.0181
0.0503
0.0000
Estimated B matrix:
0.0206
0.0000
0.0000
0.0000
0.0074
0.0000
0.0000
0.0000
0.0049
Estimated standard errors for B matrix
0.0011
0.0000
0.0000
0.0000
0.0004
0.0000
0.0000
0.0000
0.0003
A^-1*B
0.0206
0.0000
0.0000
0.0005
0.0074
0.0000
-0.0002 -0.0009
0.0049
SigmaU~*100
0.0426
0.0010 -0.0004
0.0010
0.0055 -0.0007
-0.0004 -0.0007
0.0025
end of ML estimation
Note that the ML estimates of the structural parameters also enable us to obtain an estimate of the
contemporaneous impact matrix A-1B linking t and ut (see equation (4)). Knowledge of this matrix
allows us to recover the structural shocks from the estimated residuals.
6

Generating impulse responses and forecast error variance decompositions

Two useful outputs from VARs are the impulse response function and the forecast error variance
decomposition. Impulse responses show how the different variables in the system respond to
(identified) shocks, i.e., they show the dynamic interactions between the endogenous variables in the
VAR(p) process. Since we have identified the structural VAR, the impulse responses will be
depicting the responses to the structural shocks. In other words, once the structural model has been
identified and estimated, the effects of the structural shocks ut can be investigated through an impulse
response analysis. We do this because the results of the impulse response analysis are often more
informative than the structural parameter estimates themselves.
16

The same is true for forecast error variance decompositions, which are also popular tools for
interpreting VAR models. While impulse response functions trace the effect of a shock to one
endogenous variable onto the other variables in the VAR, forecast error variance decompositions (or
variance decompositions in short) separate the variation in an endogenous variable into the
contributions explained by the component shocks in the VAR. In other words, the variance
decomposition tells us the proportion of the movements in a variable due to its own shocks versus
shocks to the other variables. Thus, the variance decomposition provides information about the relative
importance of each random shock in affecting the variables in the VAR. In much empirical work, it is
typical for a variable to explain almost all of its forecast error variance at short horizons and smaller
proportions at longer horizons. Such a response is not unexpected, as the effects from the other
variables are propagated through the reduced-form VAR with lags.
Q7. Generate impulse response functions for the identification scheme in our example.
Answer: Select SVAR and the newly highlighted option SVAR IRA (SVAR impulse response
analysis).
Now that we have identified the SVAR, this option has become available. A new screen will open up.
We first have to Specify IRA, which concerns the number of periods (60) and the nature of the
confidence intervals. A second window, Display Impulse Responses, allows us to fine-tune the exact
nature of the charts. We would like to look at all impulse responses, so we select (by holding down the
Ctrl-key while selecting series) all impulses and all responses. The following figure gives the responses
of the three variables in the VAR to the identified structural shocks, together with 95% Hall bootstrap
intervals based on 1,000 bootstrap replications:11

11

1,000 bootstrap replications may be a bit on the low side for reliable inference. But a higher number of bootstrap
replications may be rather computationally demanding (least of all on available memory when VARs with several variables
and long lags are considered) and therefore affect computing time. For reliable confidence intervals, the bootstrap literature
recommends that the number of replications should be of the order or 2,000 or more.

17

In the light of Christiano et al.s (1998) three stylised facts about the effects of contractionary monetary
policy shocks, let us analyse the impact of an (expansionary) shock to the monetary aggregate M1 on
the three variables in the VAR. These are given in the first column of the above chart. Money
obviously increases as a result of a positive shock to itself. Output shows the required J-shaped
response, albeit the other way, as the monetary policy shock is expansionary rather than contractionary.
The long-run response of output to the expansionary monetary shock is zero. The aggregate price level
responds after one year. Whether this corresponds to Christiano et al.s (1998) first stylised fact of the
price level initially responding very little is open to debate.
Q8. Generate forecast error variance decompositions for the identification scheme in our example.
Answer: Select SVAR and the newly highlighted option SVAR FEVD (SVAR forecast error variance
decomposition).
Now that we have identified the SVAR, this option has become available. A new screen will open up.
We first have to Specify FEVD, which concerns the number of periods (20). The following table gives
the variance decompositions of the three variables in the VAR to the identified structural shocks (at
four-quarter intervals to conserve space):
SVAR FORECAST ERROR VARIANCE DECOMPOSITION
Proportions of forecast error in "LM1_CN"
accounted for by:
forecast horizon
LM1_CN
LRGDP_CN
1
1.00
0.00
4
0.99
0.01
8
0.99
0.01
12
0.99
0.01
16
0.98
0.01
20
0.97
0.01

LCPI_CN
0.00
0.00
0.00
0.00
0.01
0.02

Proportions of forecast error in "LRGDP_CN"

accounted for by:
forecast horizon
LM1_CN
LRGDP_CN
1
0.00
1.00
4
0.17
0.81
8
0.23
0.73
12
0.25
0.70
16
0.27
0.68
20
0.28
0.67

LCPI_CN
0.00
0.02
0.04
0.04
0.05
0.05

Proportions of forecast error in "LCPI_CN"

accounted for by:
forecast horizon
LM1_CN
LRGDP_CN
1
0.00
0.03
4
0.02
0.02
8
0.11
0.02
12
0.26
0.08
16
0.39
0.15
20
0.48
0.21

LCPI_CN
0.97
0.97
0.87
0.66
0.46
0.31

To begin with, output and prices predict almost none of the variance of money. Of much more interest,
however, is the effect of nominal on real variables, as it is sometimes found that monetary policy shocks
explain only a small part of the variance of output. Overall, the M1 monetary aggregate accounts for a
18

little more than a quarter (28%) of the variation in output after five years (20 quarters), while shocks to
real output themselves account for two-thirds of the output variance at that horizon.
Two comments are warranted. As pointed out by Bernanke (1996), this does not mean that all monetary
policy has been unimportant. First, it could be the case that anticipated monetary policy, or more
generally, the systematic part of monetary policy, decreases the variance of output and inflation.
Second, the variance decomposition does not tell us about the potential effects of monetary policy
surprises (while the impulse response function does), only about the combination of the potential effect
with the actual monetary policy shocks for that particular sample.
6.1

Putting money last (Sims (1992))

In later work by Sims and others, monetary policy is put last instead, which means that monetary policy
is potentially affected by, but does not affect, contemporaneous macroeconomic variables. This
corresponds to the assumption that policy shocks have no contemporaneous impact on output and
represents a Choleski decomposition with output and prices ordered before the monetary policy
variable. How reasonable such an assumption might be clearly depends on the unit of observation: in
annual data, the assumption of no contemporaneous effect would be implausible; with monthly data, it
might be much more plausible.
Theoretically, changing the order of the variables does make a difference. Recall from the presentation
that the structural shocks, ut, and the observed shocks, t, are related by:
ut = Ft

(6)

With money put first, we have the following system:

u tM1 f11
GDP
u t = f21
CPI
u t f31

0
f22
f32

0 tM 1
f11 tM1

GDP
0 t =
f21 tM1 + f22 tGDP

CPI
M1
GDP
CPI

+ f33 t
f33 t f31 t + f32 t

(7)

We can see that the first two shocks are unaffected by the third shock contemporaneously. This implies,
for example, that a monetary policy shock takes time to affect the economy. On the other hand, if we
put money last, we get the following system:

u tGDP f11
CPI
u t = f21
M1
u t f31

0
f22
f32

0 tGDP
f11 tGDP

CPI
GDP
CPI
+ f22 t
0 t =
f21 t

M1
GDP
CPI
M1

+ f32 t + f33 t
f33 t f31 t

(8)

The order of the variables therefore should matter, as the variable ordered last has no contemporaneous
impact on the other variables in the system.
Q9. Estimate an unrestricted VAR. We start our estimation with LRGDP_CN, LCPI_CN and
LM1_CN, including also a constant. Select the three variables in that order, then confirm your
selection. Remember that selection order sets variable order. The chosen variables in the order in
which they were chosen appear in red in a window at the bottom of the right-hand side. Pressing Max
selects the longest sample period. Note that we are still measuring the impact of monetary policy by
positive shocks to the monetary aggregate, M1.
Answer: We estimate the VAR with three lags, a constant plus a trend.
19

In terms of the results of the impulse response analysis, prices react within one year (and rather
persistently) to monetary policy, output responds in the short run, in the long run (from ten years after
the shock onwards) prices start adjusting and the significant effect on output vanishes after some 30
quarters. There is no strong evidence for the endogeneity of money. This is easily checked by looking
at the estimated parameters in F (the A matrix in JMulTis output) and by analysing forecast error
variance decompositions. The estimated coefficients in the last row of the A matrix are insignificant, so
structural shocks to output and prices do not enter into the structural monetary policy shocks. FEVDs
are very similar to the case where money is put first in the VAR, and show that macroeconomic
variables play a very limited role in explaining the variance of the forecasting error of money, while
money instead plays an important role in explaining fluctuations of both the other macroeconomic
variables.
7

What monetary measure contains the most information?

There is a long tradition of identifying monetary policy shocks with statistical innovations to monetary
aggregates like base money (M0), M1 and M2. But which measure of money should we choose?
Walsh (1998, p. 12) provides a first clue. He illustrates correlations between the detrended log of real
US GDP and three different US monetary aggregates, each in detrended log form as well, and finds that
the correlations with real output change substantially as one moves from M0 to M2. The narrow
measure M0 is positively correlated with real GDP at both leads and lags. In contrast, M2 is positively
correlated at lags but negatively correlated at leads. The larger correlations between GDP and M2 arise
in part from the endogenous nature of an aggregate such as M2, depending as it does on the behaviour
of the banking sector as well as that of the non-bank private sector (King and Plosser (1984), Coleman
(1996)).
In order to see what effects different monetary aggregates have, we can estimate the foregoing threevariable VAR with other monetary measures, in particular M2 and M3.
20

Q10. Estimate an unrestricted VAR. We start our estimation with LRGDP_CN, LCPI_CN and
LM2_CN, including also a constant. Select the three variables in that order, then confirm your
selection. Remember that selection order sets variable order. The chosen variables in the order in
which they were chosen appear in red in a window at the bottom of the right-hand side. Pressing Max
selects the longest sample period. Note that we are now measuring the impact of monetary policy by
positive shocks to the monetary aggregate, M2.
Answer: We estimate the VAR with four lags, a constant and a trend. The results of the impulse
response analysis remain broadly unaffected: prices again react immediately (and persistently) to
monetary policy and output responds in the (very) short run (up to one year), but shows no long-run
effect. There is no strong evidence for the endogeneity of money. This is easily checked by looking at
the estimated parameters in F (the A matrix in JMulTis output) and by analysing forecast error variance
decompositions. The estimated coefficients in the last row of the A matrix for output and prices are
insignificant, so structural shocks to output and prices do not enter into the structural monetary policy
shocks:
Estimated A matrix:
1.0000
0.0000
0.0000
0.0932
1.0000
0.0000
-0.1183
0.0646
1.0000
Estimated standard errors for A matrix:
0.0000
0.0000
0.0000
0.0554
0.0000
0.0000
0.0942
0.1398
0.0000
The next exercise asks you to use the series LM3_CN. Note that the list of available time series only
contains M3_CN at the moment. In other words, we need to generate the logarithm of this series.
Select the series M3_CN by clicking on it. Various tasks on the selected variable can be accessed by a
menu that pops up when you right-click on the selected variable in the time series selector. We want to
calculate the logarithm of M3_CN, so we select Transform, which opens up a new window. We click
in the box next to logarithm, which will apply a logarithmic transformation to the selected variable in
levels. Click OK and a new series appears in the time series selector, called M3_CN_log. As we want
the name of the variable to be consistent with the other monetary aggregates, we need to rename the
series. Right-click on M3_CN_log and select Rename. We can now give M3_CN_log its new name,
which is LM3_CN.
Q11. Estimate an unrestricted VAR. We start our estimation with LRGDP_CN, LCPI_CN and
LM3_CN, including also a constant. Select the three variables in that order, then confirm your
selection. Remember that selection order sets variable order. The chosen variables in the order in
which they were chosen appear in red in a window at the bottom of the right-hand side. Pressing Max
selects the longest sample period. Note that we are now measuring the impact of monetary policy by
positive shocks to the monetary aggregate, M3.
Answer: We estimate the VAR with three lags, a constant and a trend. This time around, the results of
the impulse response analysis are somewhat different: prices again react immediately but only for about
20 quarters and except for a brief dip after five years - output does not respond in either the short- or
the long-run. There is again no strong evidence for the endogeneity of money. This is easily checked
by looking at the estimated parameters in F (the A matrix in JMulTis output) and by analysing forecast
error variance decompositions. The estimated coefficients in the last row of the A matrix are
insignificant, so structural shocks to output and prices do not enter into the structural monetary policy
shocks.
21

But it is most informative to look at the variance decompositions. Recall that M1 accounted for slightly
more than a quarter of the forecast variance of real output. What are the equivalent percentages for M2
and M3?
SVAR FORECAST ERROR VARIANCE DECOMPOSITION
Proportions of forecast error in "LRGDP_CN"
accounted for by:
forecast horizon
LRGDP_CN
LCPI_CN
1
1.00
0.00
4
0.96
0.00
8
0.96
0.00
12
0.96
0.01
16
0.95
0.02
20
0.94
0.03

LM2_CN
0.00
0.04
0.04
0.03
0.03
0.03

Proportions of forecast error in "LM2_CN"

accounted for by:
forecast horizon
LRGDP_CN
LCPI_CN
1
0.01
0.00
4
0.07
0.04
8
0.36
0.06
12
0.57
0.04
16
0.68
0.03
20
0.75
0.02

LM2_CN
0.99
0.88
0.58
0.38
0.29
0.24

SVAR FORECAST ERROR VARIANCE DECOMPOSITION

Proportions of forecast error in "LRGDP_CN"
accounted for by:
22

forecast horizon
1
4
8
12
16
20

LRGDP_CN
1.00
0.99
0.98
0.97
0.97
0.97

LCPI_CN
0.00
0.01
0.02
0.02
0.02
0.02

LM3_CN
0.00
0.00
0.00
0.01
0.01
0.02

Proportions of forecast error in "LM3_CN"

accounted for by:
forecast horizon
LRGDP_CN
LCPI_CN
1
0.00
0.01
4
0.10
0.02
8
0.28
0.04
12
0.43
0.05
16
0.52
0.06
20
0.59
0.06

LM3_CN
0.98
0.89
0.68
0.52
0.42
0.35

We can see that the percentage of variation explained by M2 and M3 drops drastically to three and two
percent respectively. For some of these reasons, broad monetary aggregates have been substituted by
narrower aggregates, such as bank reserves, for which it is easier to identify shocks mainly driven by
the behaviour of the monetary policy maker.
8

What is the monetary policy instrument?

How one measures monetary policy is a critical issue in the empirical literature and is a topic of open
and ongoing debate. What is the monetary policy instrument: a short interest rate or a (narrow)
monetary aggregate? In general, there is no clear choice for the monetary policy variable. If monetary
policy were framed in terms of strict targets for the money supply, for a specific measure of banking
sector reserves or for a particular short-term interest rate, then the definition of the monetary policy
variable might be straightforward. In general, however, several candidate measures of monetary policy
will be available, all depending in various degrees on both policy actions and non-monetary policy
disturbances. What constitutes an appropriate candidate for the monetary policy instrument, and how
this instrument depends on non-policy disturbances, will depend on the operating procedures the
monetary authority is following as it implements monetary policy.
McCallum (1983) argues that the correct measure of the monetary policy shock is the residual in a
reaction function for the monetary-policy instrument:
monetary policy instrument = f(lagged macroeconomic data) + policy shock
The crucial assumption is that the policy instrument does not depend on contemporaneous
macroeconomic data. The money stock most likely does, since money demand is probably affected by
shocks to income and prices (as well as policy shocks to the interest rate). This makes the innovation in
the money stock a mixture of the monetary policy and other shocks.
One way of selecting between a short-term interest rate and a narrow monetary aggregate would be to
follow the analysis in Bernanke and Blinder (1992). They addressed this problem from three different
angles, of which the first two can be easily replicated. In particular, they concluded that in the US, the
federal funds rate dominated both money and bill and bond rates in forecasting real variables. The
argument goes as follows. If a (short-term) interest rate is a measure of monetary policy and if
monetary policy affects the real economy, the interest rate should be a good reduced-form predictor of
major macroeconomic variables. Studying the information content of the short-term interest rate, they
found that the federal funds rate is markedly superior to both monetary aggregates and most other
23

interest rates as a forecaster of the economy. In their second approach, they argued that if a short-term
interest rate measures monetary policy, then it should respond to the central banks perception of the
state of the economy. The second test, therefore, is to estimate monetary-policy reaction functions
explaining movements in the short-term interest rate by lagged target variables. They found that their
estimated reaction functions using the short-term interest rate gave much more reasonable responses to
inflation and unemployment shocks.
Other theoretical approaches to how the monetary policy instrument is chosen include Sims (1992), who
argued that expansionary shocks to monetary policy should drive output up and lead to opposite
movements in the money stock and the interest rate. This makes Sims choose the interest rate rather
than M1 as the policy instrument since positive shocks to M1 in his analysis led to an increase in the
interest rate and a decline in output. We will therefore now include a short-term interest rate into our
analysis.
Q12. Estimate an unrestricted VAR. We start our estimation with LCPI_CN, LRGDP_CN, BR_CN
and LM1_CN as well as a constant. Select the four variables in that order, then confirm your
selection. Remember that selection order sets variable order. The chosen variables in the order in
which they were chosen appear in red in a window at the bottom of the right-hand side. Pressing Max
selects the longest sample period. Note that we can now measure the impact of monetary policy by
either changes to the base rate, BR_CN, or the monetary aggregate, LM1_CN.12 The idea is to examine
the robustness of the previous results after identifying the part of money that is endogenous to the
interest rate. Moreover, it allows one to compare the impact of monetary and interest rate shocks to
observe how both instruments affect the variables of interest in our system.
Answer: We estimate the VAR with three lags, a constant and a trend. The following chart gives the
associated impulse response functions:

12

But keep in mind that a unit shock to the base rate is an increase in interest rates and therefore a contractionary monetary
policy shock, while a unit shock in the money supply corresponds to an increase in the money supply and thus an
expansionary monetary policy shock.

24

Just as observed by Sims (1992), we also find that monetary aggregate shocks do not look like monetary
policy shocks in their effects, whereas interest rate shocks do resemble monetary policy shocks in their
effects. In his original analysis, Sims (1992) also showed that these shocks had smooth, slow effects on
prices and that they produced predictable movements in the money stock.13
In addition, Sims (1980b) showed that the fraction of the forecasting error variance in US output that
can be attributed to money stock innovations is much lower when an interest rate is added to a VAR of
money, prices and output. The idea is to see the robustness of the above results after identifying that
part of money which is endogenous to the interest rate. This finding is equally borne out for Canadian
data. The proportion of forecast error in output accounted for by the money supply drops from 28%
without a short-term interest rate to single-digit figures after the inclusion of the base rate. After 20
quarters, the short-term interest rate accounts for slightly more than half of the forecast error in output:
Proportions of forecast error in "LRGDP_CN"
accounted for by:
forecast horizon
LCPI_CN
LRGDP_CN
1
0.03
0.97
4
0.04
0.84
8
0.04
0.61
12
0.05
0.47
16
0.05
0.39
20
0.06
0.35

BR_CN
0.00
0.04
0.26
0.41
0.49
0.54

LM1_CN
0.00
0.08
0.09
0.07
0.06
0.05

Following Sims (1992) arguments, we might also be tempted to conclude that the short-term interest
rate rather than the narrow monetary aggregate is the monetary-policy instrument in Canada.
9

Some puzzles in recursively identified structural VARs

9.1

The output, liquidity and price puzzles

Eichenbaum (1992) presents a comparison of the estimated effects of monetary policy in the US using
alternative measures of policy shocks, discussing how different choices can produce puzzling results (at
least puzzling relative to certain theoretical expectations). He based his discussion on the results
obtained from a VAR containing two different combinations of the same four variables as in Sims
(1992): the price level, output, M1 as a measure of the money supply and the federal funds rate as a
measure of short-term interest rates. He considered interpreting shocks to M1 as policy shocks versus
the alternative of interpreting federal funds-rate shocks as policy shocks. He found that a positive
innovation to M1 is followed by an increase in the federal funds rate and a decline in output (the latter
being coined the output puzzle). This result is puzzling if M1 shocks are interpreted as measuring the
impact of monetary policy. An expansionary monetary policy would be expected to lead to increases in
both M1 and output. The interest rate was found to rise after a positive M1 shock, also a potentially
puzzling result; a standard model in which money demand varies inversely with the nominal interest
rate would suggest that an increase in money supply would require a decline in the nominal interest rate
to restore money-market equilibrium.
Q13. Estimate an unrestricted VAR. We start our estimation with LCPI_CN, LRGDP_CN, LM1_CN
and BR_CN as well as a constant.14 Select the four variables in that order, then confirm your
13

As indirect evidence, Sims (2007) also cites the fact that the money supply is close to a random walk, which is what you
would expect if the monetary authority is systematically smoothing interest rates and money demand is shifting around in
response to various private-sector disturbances.
14
The empirical results are robust to the other ordering of the variables, namely LM1_CN, LCPI_CN, LRGDP_CN and
BR_CN.

25

selection. Remember that selection order sets variable order. The chosen variables in the order in
which they were chosen appear in red in a window at the bottom of the right-hand side. Pressing Max
selects the longest sample period. Note that we can now measure the impact of monetary policy by
either innovations to the base rate, BR_CN, or the monetary aggregate, LM1_CN.
Answer: We estimate the VAR with three lags, a constant and a trend. The results from the impulse
responses and forecast error variance decompositions raise a number of issues. The following chart
gives the associated impulse response functions:

Starting with the responses to the money supply shock (which is given by the third column), we note the
absence of an output puzzle for Canadian data: expansionary monetary policy is followed by an increase
in output. Note, however, that the response to money innovations gives rise to the liquidity puzzle:
the interest rate declines very slightly contemporaneously in response to a monetary policy shock to
start increasing afterwards.
When Eichenbaum (1992) used innovations in the short-term interest rate as a measure of monetary
policy actions (the fourth column), a positive shock to the federal funds rate represented a
contractionary monetary policy shock. No output puzzle was found in this case: a positive interest-rate
shock was followed by a decline in the output measure. Instead, the price puzzle emerges: a
contractionary policy shock is followed by a rise in the price level. The price puzzle is that in a VAR of
output, prices, money, interest rates and perhaps some more variables, contractionary shocks to
monetary policy lead to persistent price increases. This seems to hold not just in the US but also in
several other countries, and is more pronounced if the policy instrument is taken to be a short interest
rate than a monetary aggregate. It is often not statistically significant, but it is so common that it signals
that the VAR might be misspecified. In fact, these effects are borne out for Canadian data. There is no
output puzzle and we can see that the price puzzle is statistically significant for six quarters, i.e., a
contractionary Canadian monetary policy shock is followed by a significant rise in the aggregate price
level over six quarters.
26

Sims (1992) discusses how the price puzzle could be due to a missing element in the reaction function
of the central bank. The most commonly accepted explanation for the price puzzle is that it reflects the
fact that the variables included in the VAR do not span the information set available to the monetary
policy-maker in setting the federal funds rate. Commodity prices (or other asset prices) may signal
inflation expectations, so the central bank may react now by raising interest rates, which makes inflation
somewhat lower than it would otherwise have been (but still positive). Since these prices tend to be
sensitive to changing forecasts of future inflation, they serve to proxy for some of the Feds additional
information. If commodity prices are excluded from the VAR, this may appear as monetary policy
shocks having a positive effect on inflation.
Turning to the variance decompositions, although little of the variation in money is predictable from
past output and prices, a considerable amount (almost a third) becomes predictable when past short-term
interest rates are included in the information set:
SVAR FORECAST ERROR VARIANCE DECOMPOSITION
Proportions of forecast error in "LM1_CN"
accounted for by:
forecast horizon
LCPI_CN
LRGDP_CN
1
0.00
0.01
8
0.01
0.01
12
0.01
0.01
16
0.01
0.01
20
0.01
0.02
9.2

LM1_CN
0.99
0.77
0.72
0.68
0.65

BR_CN
0.00
0.21
0.26
0.29
0.32

What about non-recursive identification?

Recall that the main requirement of identification is to ensure that we can uniquely recover all the
parameters in the Bj matrices and variance-covariance matrix D from the estimated Aj matrices and the
variance-covariance matrix of the estimated residuals. We do this by imposing the necessary n(n
1)/2 additional restrictions. Recall from the presentation that it is only the overall number of identifying
restrictions that matter; there is therefore nothing that necessarily requires identification restrictions to
follow the Wold causal chain. But there is nothing from preventing us from imposing different
identifying structure than the recursive one. Assume that data on the price level and real output emerge
only with a lag and the monetary policymaker does not respond to changes in CPI and real GDP within
the period. In addition, CPUI and real output do not respond within the period to changes in the shortterm interest rate and the money supply. In the case of the above four-variable VAR (LRGDP_CN,
LCPI_CN, BR_CN, LM1_CN), we could postulate the following system:
u tGDP f11
CPI
u t f21
BR = f
u t 31
u M1 0
t

f12

f22

f32

f33

f 43

0 tGDP

0 tCPI
=
f34 tBR f31 tGDP

f 44 tM1

f11 tGDP + f12 tCPI

f

+f

+f

+f

+f

GDP
21 t
CPI
32 t
BR
43 t

CPI
22 t
BR
33 t
M1
44 t

M1
+ f34 t

(9)

Q14. Estimate a VAR with this identification system.

Answer. Algebraically, the matrix contains the required n(n 1)/2 = (4)(3)/2 = 6 zero restrictions
required for identification. But JMulTi is unable to solve this system of equations as the first two
equations have the same restrictions and are therefore indistinguishable. They can be premultiplied by
any orthonormal (2 2) matrix and yet satisfy the same restrictions.

27

Q15. Since these two equations do not have separate interpretations, we normalise them arbitrarily by
changing f12 in the first row from unrestricted to zero. Estimate a VAR with the following identification
system:

1
* 0 0 0

0
* * 0 0
A=
;
B
=
0
* * * *

0
0 0 * *

0
1
0
0

0
0
1
0

0
0

Such a restriction yields the following system:

u tGDP f11
CPI
u t f21
BR = f
u t 31
u M1 0
t

f22

f32

f33

f 43

0 tGDP
f11 tGDP

CPI
0 t
f21 tGDP + f22 tCPI

GDP
CPI
M1
BR
BR
f34 t
+ f32 t + f33 t + f34 t
f31 t

f34 tM1
f 43 tM1 + f34 tBR

(10)

The first line in (10) shows that the structural shocks to output are equivalent to the estimated output
shocks or that structural output shocks are autonomous of the other variables in the system. The third
equation in (10) contains contemporaneously all four of the traditional arguments of liquidity preference
in an IS-LM model. For that reason, it could be labelled a money demand equation. Similarly, the
final equation in (10) could be regarded as a money supply equation. The one over-identifying
restriction cannot be rejected.
While there are some advantages to abandoning the recursive assumption, there is also a substantial
cost: a broader set of economic relations must be identified/
9.3

Taking account of the price puzzle

We now consider introducing alternative variables to our VAR. Taking inspiration from Sims (1992),
we include the nominal exchange rate, LNOM_EER_CN, as an additional variable. As a forwardlooking asset price, the exchange rate can also be expected to contain inflationary expectations.
Following Sims (1992) argument, this should enlarge the information set of the monetary-policy maker
and alleviate the price puzzle. Alternatively, you may want to perform the estimation using the
commodity price index (PCM). We therefore now estimate our VAR with the following ordering:
LCPI_CN, LRGDP_CN, BR_CN, LM1_CN and LNOM_EER_CN, that is, with the interest rate placed
before the monetary aggregate.
Q16. Determine the appropriate number of lags and whether to include a time trend in the VAR.
Answer: Three lags plus a trend appear to be sufficient to guarantee a stable VAR without problems of
serial correlation. Note, however, that the VAR does not have normal residuals! This is due to the
introduction of the interest-rate term, which has experienced large movements. Indeed, looking at the
residual diagnostics more closely, we can see the influence of large outliers in both the individual
Jarque-Bera tests as well as the ARCH-LM tests for u5 (as well as u2 and u3), the residual associated
with the base rate. This is, unfortunately, a serious problem.15
A Choleski decomposition yields the following impulse responses:

15

One way of dealing with this problem would be to introduce dummies to account for some of the larger outliers.

28

The columns of interest are the third and fourth respectively. Examining first the columns, note that an
interest rate shock leads to a fall in prices (although this is not clear on impact!), as well as a fall in
output, and money. The impact on the exchange rate appears to be insignificant. The money shock
increases prices and output (this is as before, although the magnitude as well as the time profile of the
impulse responses have changed), it increases the interest rate (this suggests a Fisher-type effect rather
than a standard Keynesian liquidity effect) and causes an insignificant depreciation of the currency.
The Fisher effect has been documented in the US data by a number of authors. Note that a significant
price puzzle for Canada (the observation that on impact, an interest rate shock increases prices) is still
present, but now only persists for two quarters. (Using LPCM instead of LNOM_EER_CN makes the
price puzzle insignificant you can do this as an additional exercise if you want to!)
10

Recursive versus non-recursive identification

Sims (1986), for example, estimates a VAR including real GDP (y), real business fixed investment
(inv), the GDP deflator (p), the money supply as measured by M1 (m), the unemployment rate (un) and
the Treasury bill rate (r). An unrestricted VAR was estimated with four lags of each variable and a
constant term. Sims obtained the 36 impulse response functions using a Choleski decomposition with
the ordering y inv p m un r. Some of the impulse response functions had reasonable
interpretations. But the response of real variables to a money supply shock seemed unreasonable. The
impulse responses suggested that a money supply shock had little effect on prices, output or the interest
rate. Given a standard money demand function, it is hard to explain why the public would be willing to
hold the extended money supply.
Q17. Are these results borne out using a similar VAR for Canada? We estimate a VAR with the
variables ordered as LRGDP_CN, LRINV_CN, LCPI_CN, LM1_CN, UN_CN and BR_CN. Three
lags, a constant plus a trend appear to be sufficient to guarantee a stable VAR without problems of serial
correlation using the LMF test. Note, however, that the VAR does not have normal residuals!
A Choleski decomposition yields the following impulse responses (with 500 bootstrap replications):
29

In contrast to Sims finding for the US, the responses of real variables to a money supply shock do not
seem unreasonable with Canadian data.
Sims proposes an alternative to the Choleski decomposition that is consistent with money-market
equilibrium. He restricts the F matrix from the presentation (or the A matrix in JMulTi) such that:
1

0
a
31
a 41
a
51
0

a12

a32

0
a52

a 43
a 53

1
0

a 64

0 a16 yt u yt

0 0 invt u invt
0 a36 pt u pt

0 a 46 mt u mt
1 a56 unt u unt
0 1 rt u rt

Note that there are 17 restrictions on the matrix, which is therefore overidentified; with six variables,
exact identification requires only K(K 1)/2 = 15 restrictions. Note also that the restrictions are no
longer recursive. Imposing these restrictions, Sims identifies the following six relationships among the
contemporaneous innovations:
uyt = yt + a12invt + a16rt
uinvt = invt
upt = pt + a31yt + a32invt + a36rt
umt = mt + a41yt + a43pt + a46rt
uunt = unt + a51yt + a52invt + a53pt + a56rt
urt = rt + a64mt

(11)
(12)
(13)
(14)
(15)
(16)

Sims views (14) and (16) as money demand and money supply functions respectively. In (16), the
money supply should rise as the interest rate increases. The demand for money in (14) should be
30

positively related to income and the price level and negatively related to the interest rate. Investment
innovations in (12) are completely autonomous. Otherwise, Sims sees no reason to restrict the other
equations in any particular fashion.
Structural VAR Estimation Results
ML Estimation, Scoring Algorithm (see Amisano & Giannini (1992))
Convergence after 1 iterations
Log Likelihood: 2569.4532
Structural VAR is over-identified with 2.0000 degrees of freedom
LR Test: Chi^2(2.0000): 18.0297 , Prob: 0.0001
Estimated A matrix:
1.0000 -0.0999
0.0000
0.0000
0.0000
1.0000
0.0000
0.0000
-0.4485
0.1025
1.0000
0.0000
-14.0244
0.0000 -32.7412
1.0000
7.0545
2.4715 -1.7159
0.0000
0.0000
0.0000
0.0000 169.8628

0.0000
0.0000
0.0000
0.0000
1.0000
0.0000

-0.0049
0.0000
-0.0056
-0.0829
0.0369
1.0000

Estimated standard errors for A matrix:

0.0000
0.1381
0.0000
0.0000
0.0000
0.0000
0.0000
0.0000
0.0000
0.0000
17.5999
1.8965
0.0000
0.0000
0.0000
195.6438
0.0000 394.7980
0.0000
0.0000
3.1851
1.0740
4.1272
0.0000
0.0000
0.0000
0.0000
0.0000 683.9101
0.0000

0.1132
0.0000
0.0310
1.4554
0.0211
0.0000

The estimated coefficients and their associated standard errors show how poorly estimated the
coefficients in the A matrix are; in fact, only two of the 13 parameters are actually statistically
significant at the 5% level (a51 and a52), so only the unemployment rate equation contains significant
parameters. Moreover, the two overidentifying restrictions can actually be rejected. As could have
been conjectured from the impulse response functions, Sims model does not seem to hold for Canada.
11

Extending monetary policy SVAR analysis to the open-economy

Identifying exogenous monetary policy shocks in an open economy can lead to substantial
complications relative to the closed-economy case, and papers that have examined the effects of
monetary policy shocks in open economies have been distinctly less successful in providing accepted
empirical evidence than the VAR approach in closed economies
Q18. Canada is a small open economy, affected by the US. To reflect this we now add a US block. To
add the US components, we can add the US variables of interest to our VAR as either endogenous or
exogenous.
Answer: For the endogenous VAR, estimate a VAR with variables in the following order: LCPI_US,
LRGDP_US, BR_US, LCPI_CN, LRGDP_CN, BR_CN and LNOM_EER_CN, in other words, we
order the US variables first (think why?).
OPTIMAL ENDOGENOUS LAGS FROM INFORMATION CRITERIA
endogenous variables:
BR_CN LNOM_EER_CN
deterministic variables:
sample range:

LCPI_US LRGDP_US BR_US LCPI_CN LRGDP_CN

CONST
[1964 Q1, 2005 Q1], T = 165
31

optimal number of lags (searched up to 12 lags of levels):

Akaike Info Criterion:
3
Final Prediction Error:
3
Hannan-Quinn Criterion:
2
Schwarz Criterion:
1
Information criteria suggest lag lengths between one and three, but you will find that JMulTi is no
longer able to calculate residual test statistics with more than five lags. We therefore use the HannanQuinn criterion and estimate a VAR with two lags and a constant. The VAR is stable but the residual
properties are autocorrelated and not normal. We will also have to limit the bootstrap replications to
500.

(We have not plotted the US variables to save space.) A number of observations are worth mentioning
and there are some interesting results. In cases of non-normality, we have to be careful about the
interpretation of the results, as asymptotic confidence intervals are likely to be suspect. But we have
bootstrapped our confidence intervals, so we can be more confident about interpreting the results. US
variables do appear to affect some Canadian variables: higher prices in the US lead to higher prices in
Canada, and while higher output in the US does not increase Canadian prices, higher output in the US
increases output in Canada. It is interesting to note that higher US GDP and higher US interest rates
increase interest rates in Canada, suggesting that the Canadian monetary authorities may be looking at
some US variables. It is also interesting to note that the exchange rate seems to react longer term to US
interest rates as well as to its own shock.

32

12

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34