Secret Ingredients? The Informational Contribution of Factors to Standard VAR Analysis
39 Pages Posted: 17 Sep 2010
Date Written: August 27, 2010
Abstract
Recent work with Factor-Augmented Vector Autoregression (FAVAR) suggests that standard VAR analysis can be improved by incorporating the information in a large number of macroeconomic time series. I examine what new information FAVAR factors contribute. Using a sparse modification to principal components, I find that 1) extracted factors (and their impulse responses) have a natural economic interpretation and 2) a particular small-scale VAR specification closely reproduces the results of standard FAVARs on US data. My results suggest that three leading economic indicators - private payroll employment, the NAPM purchasing managers’ index, and housing starts - substantially capture the extra information introduced by FAVAR.
Keywords: Factor-Augmented Vector Autoregression, VAR, FAVAR, Monetary Policy, Principal Components
JEL Classification: E31, E4, E52, C32
Suggested Citation: Suggested Citation
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