Embedding Rational Expectations in a Structural VAR: Internal and External Instruments for Set Identification

Abstract

We propose a novel approach that embeds Rational Expectations (RE) into a low- dimensional structural vector autoregression (SVAR). We establish an instrumental variable procedure internal to the SVAR founded on a purely theoretical framework, which does not rely on any mapping strategy to a reduced form. Alternatively, a separate strategy considers data external to the SVAR to aid in the identification of structural shocks on a purely empirical basis. We report clouds of responses from an RE-consistent theoretical model as well as regions of plausible responses from the empirical approach. We conclude that a Taylor Rule characterization of monetary policy shocks remains relevant when the theoretical RE-SVAR is properly augmented with information from fluctuations—or momentous events—in markets that garnered increased attention since 2008, such as reserves and various money markets.

Keywords: Monetary Policy, rational expectations VAR, external variable instruments, sequential identification, event-based shock identification, regime-dependent monetary trans- mission

JEL Classification: E3, E4, E5