Kiel Institute of World Economics

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24105 Kiel (Germany)

Kiel Working Paper No. 1072

An Introduction into the SVAR

Methodology: Identification, Interpretation
and Limitations of SVAR models
by

Jan Gottschalk

Preliminary, this version: August 2001

The responsibility for the contents of the working papers rests with the
author, not the Institute. Since working papers are of a preliminary
nature, it may be useful to contact the author of a particular working
paper about results or caveats before referring to, or quoting, a paper.
Any comments on working papers should be sent directly to the author.
 An Introduction into the SVAR Methodology:
Identification, Interpretation and Limitations
of SVAR models*

Abstract:

This paper aims to provide a non-technical introduction into the SVAR

methodology. Particular emphasize is put on the approach to identification in
SVAR models, which is compared to identification in simultaneous equation
models. It is shown that SVAR models are useful tools to analyze the dynamics
of a model by subjecting it to an unexpected shock, whereas simultaneous
equation models are better suited for policy simulations. A draw back of the
SVAR methodology is that due to the low dimension of typical SVAR models
the assumption that the underlying shocks are orthogonal is likely to be fairly
restrictive.

Keywords: Structural Vector Autoregressions, Identification, Impulse

Response Analysis

JEL Classification: C32, C51

Jan Gottschalk
Institut für Weltwirtschaft
24100 Kiel
Phone: +49 431 8814 367
Fax: +49 431 8814 525
E-mail: jan.gottschalk@ifw.uni-kiel.de

* I am grateful to Kai Carstensen, Jörg Döpke and Robert Kokta for helpful comments. Any
remaining errors are mine alone. I also would like to thank the Marga and Kurt Möllgaard
Foundation for financial support.
 Contents

A. Introduction................................................................................... 1
B. Identification in macroeconometric models – A traditional
perspective ..................................................................................... 2
I. A review of the identification problem........................................ 2
II. Identification in dynamic simultaneous equation models ............. 4
1. Identification of the money supply schedule .......................... 7
2. Identification of the aggregate demand schedule .................... 10
III. Objections to the traditional approach to identification in
dynamic simultaneous equation models ...................................... 11

C. The SVAR methodology................................................................. 13

I. The SVAR model ...................................................................... 13
II. Identification in the SVAR model............................................... 17
1. The orthogonality restriction................................................. 17
2. The normalization of the SVAR model.................................. 19
3. Restrictions on the matrix Γ .................................................. 20
4. Identification in SVAR models compared to the traditional
approach to identification...................................................... 24
III. Dynamic multipliers versus impulse response functions .............. 25

D. Objections to the SVAR methodology............................................ 28

I. What do the shocks mean? ......................................................... 28
II. Do the SVAR measures of monetary policy shocks make sense? . 30
III. The use of informal restrictions in the identification of shocks..... 32
IV. What are SVAR models good for?.............................................. 34
V. The orthogonality restriction ...................................................... 35
E. Conclusion...................................................................................... 39

F. References...................................................................................... 40
A. Introduction

Structural vector autoregression (SVAR) models have become a popular tool in

recent years in the analysis of the monetary transmission mechanism and
sources of business cycle fluctuations.1 The SVAR methodology is now also
widely implemented in standard econometric software packages like EViews or
RATS, which makes it possible to make use of this methodology in relatively
simple and straightforward ways.2 This paper aims to provide a non-technical
introduction into the SVAR analysis. Since many applied macroeconomists are
familiar with the use and estimation of traditional structural models like
dynamic simultaneous equation models, this paper takes this class of models as
a starting point. A crucial issue in the estimation of a structural model is always
the identification of the empirical model. For this reason, this paper begins in
section 2 with a review of the identification problem and illustrates the
identification of a dynamic simultaneous equation models using a simple
example. In section 3 the SVAR methodology is introduced. The identification
problem is the same as that in a dynamic simultaneous equation model, but
SVAR models take another approach to achieve identification by focusing on
the role of shocks for the dynamics of the model. This approach avoids some of
the difficulties inherent in the traditional approach to identification, but it also
implies that SVAR models cannot perform the same tasks as dynamic
simultaneous equation models. In the field of monetary economics, for example,
SVAR models are not well suited for policy simulations, which is a strength of
the dynamic simultaneous equation models, but have instead an advantage in the
analysis of the monetary transmission mechanism. The SVAR methodology has
not remained without criticism. In section 4 a number of objections to SVAR
models are reviewed. These include doubts regarding the interpretation and
importance of shocks, reservations about the undisciplined use of informal

__________
1 For a survey on the use of SVAR models in the monetary transmission mechanism see
Christiano et al. (1999). The seminal paper popularizing the use of SVAR models in the
analysis of the source of business cycle fluctuations is Blanchard and Quah (1989).
2 For RATS the software package Malcolm is available, which is dedicated to SVAR
analysis.
 2

restrictions and scepticism whether the assumptions that the identified shocks
are uncorrelated can be justified. The final section offers a brief conclusion.

B. Identification in macroeconometric models – A traditional

perspective

I. A review of the identification problem3

Since dynamic simultaneous equation models and SVAR models mostly differ
in their approach to identification, we review first the identification problem all
empirical macroeconomic models have to confront in the estimation of structural
parameters.4 The identification problem can be illustrated with the help of the
following structural model, which is assumed to represent the ‘true’ structure of
the economy,

(1) Γ Yt = BX t + et ,

where Yt is a (n x 1) vector of the endogenous variables, X t contains the

exogenous and lagged endogenous variables and Σ e = E (ee' ) gives the
variance-covariance matrix of the structural innovations.5 The coefficients in Γ
and B are the parameters of interest. The fundamental problem in the estimation
of structural models is that one cannot directly estimate (1) and derive the ‘true’
values of Γ and B . The sampling information in the data is not sufficient for
this to be feasible without further identifying restrictions. There is an infinite set
of different values for Γ and B which all imply exactly the same probability
distribution for the observed data, which makes it impossible to infer from the
data alone what the true values for Γ and B are; hence, these parameters are
said to be ‘unidentified’.
__________
3 The following discussion draws heavily on Faust (1998), Bagliano and Favero (1998) and
Leeper et al. (1996).
4 For a discussion of the different approaches to identification proposed in the literature see
Favero (2001).
5 All variables are written in logarithms.
 3

To demonstrate this problem, the reduced form of model (1) is derived, which
summarizes the sampling information in the data set. The reduced form
expresses each endogenous variable solely as a function of predetermined
variables:6

(2) Yt = B* X t + ut ,

with B* = Γ−1B and ut = Γ −1et ; the variance-covariance matrix of the reduced

form is given by Σ u = E (uu' ) .
Next, we consider a different structural model. This model is obtained by
premultiplying the model (1) by a full rank matrix Q, which leads to the new
model (3):

(3) Q ΓY t = QBX t + Qe t ,

(4) ΓQ Y t = BQ X t + eQ t ,

with ΓQ = QΓ , BQ = QB and eQ t = Qet .

The reduced form of model (3) is given by

(5) Yt = ΓQ−1BQ X t + ΓQ−1eQ t = Γ −1Q −1QBX t + Γ −1Q −1Qet = Γ −1BX t + Γ −1et .

In other words, the reduced form of model (3) is equal to

(6) Yt = B* X t + ut ,

which coincides with the reduced form of model (1). This implies that both
models are observationally equivalent. This is the identification problem: With-
out additional assumptions, so-called identifying restrictions, no conclusions
regarding the structural parameters of the ‘true’ model can be drawn from the
data, because different structural models give rise to the same reduced form.

__________
6 See Hamilton (1994), p. 245.
 4

II. Identification in dynamic simultaneous equation models 7

To provide some background on the origins of the structural vector

autoregression approach, we show first how a dynamic simultaneous equation
model is identified using the traditional approach to identification and then
discuss the potential problems arising from this approach. Since the SVAR
methodology was developed in response to these problems, it is helpful to have
an understanding of the difficulties inherent in the traditional approach to
identification.
The identification of Γ and B requires a set of restrictions that rule out all but
one Q.8 The matrix Q has n 2 elements that need to be pinned down by the
identifying restrictions. Of those n 2 restrictions, n restrictions are simply nor-
malizations that pick the units of the coefficients. In the traditional approach to
identification the other (n −1)n identifying restrictions are obtained by imposing
linear restrictions on the elements of the matrices Γ and B .9 Often exclusion
restrictions are used for this purpose. Note that in the traditional approach to
identification the variance-covariance matrix of the structural disturbances Σ e is
usually left unrestricted: In particular, it is not assumed that the structural distur-
bances are orthogonal. This is the crucial difference with identification in SVAR
models.
In the remainder of this section we demonstrate how a dynamic simultaneous
equation model is identified with the help of a simple bivariate model consisting
of an output ( yt ) and a money stock variable ( m t ). The first variable is intended
to represent a non-policy macroeconomic variable while the second variable
represents the monetary policy instrument. The structural model is assumed to
have the form

(7) yt = γ 1mt + Byy ( L) yt + B ym ( L) mt + ed t

__________
7 For a more detailed discussion of simultaneous equations models see Hansen (1991), pp.
339. These models are also called ‘Cowles Commission Models’. See Favero (2001), pp.
88.
8 See Faust (1999), pp. 5.
9 Moreover, the identifying restrictions have to fulfill the rank and order conditions for
identification. For a discussion see Greene (1997), pp. 724.
 5

(8) mt = γ 2 yt + Bmy ( L) yt + Bmm ( L)mt + ems t ,

where B( L) denotes polynomials in the lag operator L and Σ e is again the

variance-covariance matrix of the structural disturbances.10 The first equation
shows the impact of the monetary policy instrument on real activity. This
equation is interpreted as an aggregate demand relation parsimoniously
specified. An equation like (7) is often used to obtain estimates of the so-called
dynamic multipliers of monetary policy which describe the impact of the
monetary policy instrument on output. The dynamic multipliers are useful, for
example, to determine the value to be assigned to m t to achieve a given path for
the macroeconomic variable yt .11 The second equation can be interpreted as a
money supply function. Here, we assume that the central bank sets the money
supply according to a feedback mechanism involving current output and the
history of both variables, while discretionary policy actions are captured by the
money supply shock ems .
As discussed in the preceding section, there is no way to obtain estimates of
the structural parameters of interest without some identifying restrictions. The
reduced form of (7) and (8) is given by the following set of equations,

(9) y t = B *yy ( L ) y t + B *ym ( L ) mt + ud t

(10) mt = Bmy
* ( L) y + B * ( L ) y + u
t mm t ms t ,

where B * = Γ −1B and u = Γ −1e , as before. Assuming a uniform lag length of k it

is apparent that the reduced form represented by (9) and (10) has 4k coefficients
while the structural model represented by (7) and (8) has (4k + 2) coefficients,
so one identifying restriction for each equation is needed to obtain estimates of
the structural parameters from the data.
As noted above, identification in simultaneous equation models is typically
achieved by imposing exclusion restrictions on the elements of the matrices Γ
and B . These restrictions are imposed on the model on a priori grounds and

__________
10 The lag polynomial B( L) takes the general form B(L ) = b1L + b 2 L2 + ... + b n Ln .

11 See Bagliano and Favero (1998), pp. 1071.

 6

cannot be tested. For this reason they should be based on a firm theoretical
foundation.
Regarding restrictions on Γ , one could argue that due to lags in the collection
of statistics on economic activity monetary policy makers cannot observe output
within the period, and, therefore, cannot respond contemporaneously to the
output variable. This would suggest restricting the parameter γ 2 to zero. One
could also argue that monetary policy affects output only with a delay due to
lags in the transmission mechanism. According to this argument, the parameter
γ 1 could be set to zero. With these two restrictions the matrix Γ becomes the
identity matrix and the reduced form given by (9) and (10) actually represents a
structural model of the economy. For the moment, we will not pursue
restrictions on the simultaneous relationships between the variables further, but
return to this issue in the context of the SVAR analysis where this type of
restriction is very popular.
The model can also be identified by imposing restrictions on the elements of
the matrix B . The matrix B describes the effects of the lagged endogenous
variables on output and money. That is, this matrix describes the dynamic
relationships between the variables in the model. The lagged endogenous
variables are predetermined, meaning that they do not correlate with the
contemporaneous or future realizations of the structural shocks. Variables that
are predetermined can be treated, at least asymptotically, as if they were
exogenous.12 Even though this makes these variables easy to handle empirically,
restrictions on lagged endogenous variables are difficult to justify from a
theoretical perspective, since economic theory usually does not say much
regarding the dynamic relationships between variables, and for this reason it is
preferable to let these coefficients be determined by the data. 13 In SVAR
models, no restrictions are imposed on the elements of B .
Another approach is to search for exogenous variables to help with identifi-
cation. 14 A variable is defined as strongly exogenous if it does not correlate with

__________
12 See Greene (1997), p. 714.
13 For a discussion see also Amisano and Giannini (1997), pp. 22.
14 Inclusion of exogenous variables increases the chances for the model to be identified. See
Favero (2001), pp. 88.
 7

the contemporaneous, future or past realizations of the structural shock in the

equation. 15 This is a stronger condition than that holding for predetermined
variables, but from the standpoint of identification both types of variables can be
treated in a similar manner. 16 Since the use of exogenous variables for
identification is specific to dynamic simultaneous equation models in the sense
that SVAR models consist only of endogenous variables, we concentrate in the
following on the role of exogenous variables in the identification of our small
simultaneous equation models. This will prove useful in bringing out the
fundamental difference in identification between dynamic simultaneous equa-
tion models and SVAR models. As regards the structural model considered here,
we need at least two exogenous variables to achieve identification. One of those
two variables should be highly correlated with the aggregate demand variable
but not with the policy instrument, whereas the opposite should hold for the
other variable. In the following two subsections we illustrate how exogenous
variables which fulfill these requirements can help with the identification of the
money supply and the aggregate demand relations.

1. Identification of the money supply schedule

To illustrate the identification principle for the money supply relation, we make
the reasonable assumption that fiscal policy, which is exogenous to our model, is
a major determinant of aggregate demand conditions, but is not a factor in the
setting of the monetary policy course. That is, we assume that this variable can
be restricted on a priori grounds to be irrelevant for the determination of money
supply. Setting the coefficient for this variable to zero in the money supply
equation provides the identifying restriction needed to estimate the structural
parameters in this equation. The identification principle is illustrated with the
help of the following diagram:

__________
15 See Hansen (1991), p. 340.
16 See Greene (1997), pp. 714, and Favero (2001), pp. 88.
 8

Figure 1: Identifying the money supply schedule

MS
dG 2 B
x
A
x
C
x dG 1

AD 2 AD 0 AD 1

Figure 1 plots the money supply schedule MS and the aggregate demand
schedule AD . Initially, the system is at point A . Next, fiscal policy is assumed
to become expansionary, which is denoted by dG1 . According to the identifying
restriction this change in the fiscal policy stance only shifts the aggregate
demand schedule, but not the money supply schedule. As regards this point,
recall that the fiscal policy coefficients in the money supply function have been
set to zero, so that there is no direct response of the money supply to the fiscal
policy stance. This restriction ensures that the money supply schedule is pinned
down in Figure 1 with respect to the fiscal policy stance. Following the fiscal
impulse, the system reaches a new equilibrium in B . Next, fiscal policy is
assumed to become restrictive ( dG2 ), moving the system to C . To see how this
procedure identifies the money supply equation, it is useful to notice that the
points A , B and C provide a good description of the money supply schedule
MS . In other words, changes in the fiscal policy stance are an exogenous source
of shifts in the aggregate demand schedule and help to trace out the MS
schedule, which is being pinned down by the identifying restriction.
With the help of the fiscal policy variable and the accompanying identifying
restriction it also possible to use regression analysis methods like the two-stage
least square method to obtain consistent estimates of the structural parameters in
 9

the money supply equation. 17 Using an instrumental variables approach like

two-stage least squares, the fiscal policy variable serves in the estimation of
equation (8) as an instrument variable for the contemporaneous output variable.
For the discussion of this approach it is useful to reformulate the identification
problem: If one estimates equation (8) using ordinary least squares (OLS), this
would lead to an inconsistent estimate of the parameter γ 2 , because the
resulting estimate would represent an average of the structural parameters γ 1 and
γ 2 , with weights depending on the sizes of the variances of the structural
disturbances ed and ems . This is known as simultaneous equation bias. 18
Technically, this bias arises because for the contemporaneous output variable in
equation (8) the condition is violated that the determining variable needs to be
independent of the disturbance term if the OLS estimator is to be consistent. 19
The source of the problem is that the contemporaneous output variable is an
endogenous variable and, therefore, it is correlated with the disturbance term
ems ,t . In other words, the OLS estimate of γ 2 is biased because output and
money in our model are simultaneously determined and, hence, the output
variable is a function of the disturbance term of the money supply equation. The
intuition behind the instrumental variables approach is that by using for the
endogenous determining variable an instrument which is uncorrelated with the
disturbance term this approach reestablishes the orthogonality between the
determining variable and the disturbance term, thereby obtaining a consistent
estimator. 20
In our case the instrumental variables approach requires a variable that is
highly correlated with the contemporaneous output variable, but uncorrelated
with ems ,t . The fiscal policy variable is such an instrument. On the one hand,
this variable is likely to be highly correlated with output because it is an
important factor for aggregate demand conditions. On the other hand, it is
uncorrelated with the disturbance term ems ,t , because fiscal policy is assumed to

__________
17 See Hamilton (1994), pp. 238.
18 See Hamilton (1994), p. 234.
19 See Favero (2001), p. 107.
20 For a detailed exposition of the instrumental variables estimator, see Favero (2001), pp.
108.
 10

be an exogenous variable and, therefore, it is not a function of the money supply

variable. 21 Finally, according to our identifying restriction fiscal policy is not a
determining variable in the money supply equation. If it were, it could not
simultaneously serve as an instrument for another determining variable in this
equation. In other words, the fiscal policy variable would not add a new source
of information to our estimation problem in this case. But our identifying
restriction rules this case out, thereby ensuring that the fiscal policy variable is a
valid instrument.

2. Identification of the aggregate demand schedule

For the estimation of the structural parameters in the aggregate demand relation
an instrument is needed that is correlated with the money supply variable but not
with the disturbance term ed ,t . Moreover, this variable should not be a factor in
determining aggregate demand. Finding such a variable poses a considerable
challenge. One candidate is the term spread. This variable is correlated with
money supply if monetary policymakers accommodate shifts in money demand
due to portfolio reallocations, which are due to exogenous changes in the term
spread.22 In addition, one has to assume that the term spread is exogenous with
respect to output, to ensure that it is not correlated with the disturbance term e d .
That is, it is assumed that the term spread is not influenced by aggregate demand
conditions. This is harder to justify; for instance, in an economic upswing the
demand for long-term capital typically rises, leading to higher long-term interest
rates and thereby increasing the term spread.23 Finally, one has to assume that
the term spread has no direct effect on aggregate demand, which represents our
identifying restriction. This assumption is also hard to justify if agents are
forward looking. We will return to this issue below. If all three assumptions
__________
21 If the exogeneity assumption does not hold the fiscal variable would be just another
endogenous variable like output. In this case the model given by (7) and (8) should be
extended by an additional equation modeling the fiscal policy stance as a function of the
contemporaneous monetary policy stance.
22 The term spread is often used to model the opportunity costs of holding money. Changes
in this variable lead therefore to changes in money demand. For an empirical model of
money demand with this specification, see for example Coenen and Vega (1999).
23 For a discussion of the determinants of the yield spread, see Berk and Van Bergeijk
(2000), pp. 5.
 11

hold, movements in the term spread shift the money supply function and thus
help to trace out the aggregate demand schedule, which remains fixed.
Another common assumption for the estimation of the aggregate demand
relation is that the money variable in (7) is not an endogenous but an exogenous
variable. 24 With this assumption no identification problem arises in the first
place. This allows us to estimate (7) in a straightforward way using ordinary
least squares, because the problem of endogenous money is not an issue
anymore. In terms of Figure 1 the money supply schedule is vertical. This
assumption would hold, for example, if the central bank sets the money supply
according to some predetermined schedule (for example a k% rule). This
assumption has an interesting but often unnoticed implication for the variance-
covariance matrix of the structural disturbances, Σ e : Since money is exogenous
with respect to output, the coefficients in γ 2 and Bym ( L) in the money supply
equation are zero and, moreover, the money variable is uncorrelated with the
aggregate demand disturbance ed . From this follows that the structural dis-
turbances ed and ems are orthogonal. 25 This result will be of some significance
in the comparison of identification in dynamic simultaneous equation models
and SVAR models.

III. Objections to the traditional approach to identification in

dynamic simultaneous equation models

What, if any, are the problems with this approach to identification? A forceful
critique comes from Sims (1980) who argues that truly exogenous variables are
hard to come by. He notes that many exogenous variables in large macro-
economic models are treated as exogenous by default rather than as a result of
there being a good reason to believe them to be strictly exogenous.26 Regarding
policy variables, he points out that these typically have a substantial endogenous

__________
24 For a discussion, see Bagliano and Favero (1998), pp. 1071, and Sims et al. (1996), pp. 6.
25 See also the discussion in Sims et al. (1996), pp. 6.
26 See Sims (1980), p. 5.
 12

component, which precludes treating them as exogenous.27 Moreover, Sims

argues that there are only a few powerful a priori identifying restrictions.28 This
holds in particular when one allows for agents forming their decisions on the
basis of rational expectations and inter-temporal optimization. The textbook
paradigm for identification is a simultaneous equation model for the supply and
demand of an agricultural product. In this example, a weather variable is used as
an instrument to identify the demand schedule. That is, the identifying
restriction is imposed on the model that weather does not affect the demand for
the agricultural good directly. Sims argues that even this assumption is
undermined if one allows for expectations: “However certain we are that the
tastes of consumers in the U.S. are unaffected by the temperature in Brazil, we
must admit that it is possible that U.S. consumers, upon reading of a frost in
Brazil in the newspapers, might attempt to stockpile coffee in anticipation of the
frost’s effect on price. Thus variables known to affect supply enter the demand
equation, and vice versa, through terms in expected price.”29
The fact that identifying restrictions are often controversial can also be
illustrated with the restrictions that have been imposed on the small structural
model considered here. Beginning with the identification of the money supply
relation, it has been argued that the direct effect of fiscal policy on money
supply can be restricted to zero on a priori grounds. Barro (1977) disagrees: In
an influential paper he argues that due to the seignorage to be gained from
expanding the money supply there is an incentive for the government to fall
back on this source of revenue when fiscal expenditure rises above trend.
Accordingly he models the money supply in his model as a function of a fiscal
policy proxy, while the effect of this variable on his aggregate demand variable
is restricted to zero. Thus, Barro uses exactly the opposite identifying restriction
than the one used here, where fiscal policy was assumed to be an important
factor for demand fluctuations, but not for the monetary policy stance.
The identifying restriction involving the term spread is also open to challenge.
For the identification of the aggregate demand relation we assumed that the
__________
27 See Sims (1980), p. 6. For a similar argument see Bagliano and Favero, p. 1072.
28 See Sims (1980), p. 4.
29 Sims (1980), p. 6.
 13

spread does not enter this relation as a determining variable. However, in New
Keynesian models it is typically assumed that current real spending depends on
the expected future level of real spending. 30 Since the term spread is often used
as a predictor of future economic activity, one would expect this variable to have
a direct effect on current aggregate demand, thereby invalidating the identifying
restriction. 31
Since the identifying restrictions used so far are vulnerable to criticism, this
would suggest searching for another set of exogenous variables to help with the
identification of the aggregate demand and the money supply relations, but the
challenge to find a new set of exogenous variables returns the discussion to the
first point stressed by Sims, namely that there are not so many credible exoge-
nous variables to begin with. This example illustrates that it is quite hard to find
suitable instruments for identification in the traditional dynamic simultaneous
equation approach.

C. The SVAR methodology

I. The SVAR model

The preceding discussion of the traditional approach to identification provides

an useful background for the SVAR methodology. The bivariate structural
model introduced in the last section is used here as well to demonstrate the
SVAR approach to identification. But before we can discuss this issue, we need
to introduce the SVAR model itself. For this purpose is useful to rewrite the
structural model given by (7) and (8) in matrix form, which leads to

(11) Γ Yt = B ( L )Y t + et ,

__________
30 For a discussion of the forward-looking IS equation see King (2001), p. 50.
31 See the discussion in Berk and Van Bergeijk (2000).
 14

 yt   1 −γ1   B yy ( L ) B ym ( L ) 
with Y =   , Γ =   B ( L) =  
 − γ2 1 , and
t
 mt   Bmy ( L ) B mm ( L ) 
 σ d2 σ dms 
Σe =   , where σd2 gives the variance of the demand innovations,
σ
 dms σ 2
ms 
2
σ ms denotes the variance of the money supply innovations and σ dms is the
respective covariance.
The starting point of the SVAR analysis is the reduced form of (11), which in
matrix notation is given by

(12) Yt = Γ−1 B( L)Yt + Γ −1et , or

(13) Yt = B* ( L)Yt + ut ,

where, as before, B* = Γ−1B and ut = Γ −1et . The variance-covariance matrix of

the reduced form can be written as Σu = Γ −1Σe Γ −1 ' . Model (13) is a convenient
point of departure because this system can be estimated together with Σ u in a
straightforward way as a vector autoregression (VAR) model. A VAR is a
system where each variable is regressed on a constant (and a deterministic time
trend, if necessary) and on k of its own lags as well as on k lags of the other
variables. In other words, each equation in the VAR contains the same set of
determining variables. This allows to estimate the VAR using ordinary least
squares.
Next, the moving average (MA) representation of (13) is computed, meaning
that the system is reparameterized to express the endogenous variables in Yt as a
function of current and past reduced form innovations, ut . The MA form can be
obtained by rearranging (13), leading to

(14) Yt = ( I − B* ( L))−1 ut , or

(15) Yt = C ( L)ut ,

with C ( L) = (I − B * ( L)) .32 A comparison of the MA representation (15) with

−1

the conventional autoregressive (AR) representation (13) shows that in the AR

__________
( )
32 It is assumed here that the polynomial I − B * (L ) is invertible.
 15

representation the output variable is expressed as a function of past values of

output and money, whereas in the MA representation output is expressed as a
function of current and past innovations in ud and ums . The same holds for the
money variable. Even though both forms appear to be very different from each
other, they are nevertheless nothing but different representations of the same
system.
For a better understanding of the MA representation it may help to write (15)
out,

 yt   ud , t   C dd ,1 C dms,1  ud , t −1   C dd ,2 C dms, 2  ud , t − 2 
(16)  = +  +   + ... .
 m t   ums,t   C msd,1 C msms,1  ums,t −1   Cmsd , 2 Cmsms,2  ums, t − 2 

To demonstrate the interpretation of the matrix polynomial C ( L ) in (16), we use

the coefficient C cc ,2 as an example: Since this coefficient can be expressed as
∂ yt +2
= C dd , 2 , it follows that Cdd ,2 represents the response of output in period
∂ ud ,t
t + 2 to a unit innovation in the disturbance term ud occurring in period t ,
holding all other innovations at all other dates constant. 33 Accordingly, a plot of
Cdd ,s as a function of s gives the response of output in time to a unit innovation

in u d ,t . The resulting plot is called the impulse response function of output to an

unit innovation in ud , t .
To illustrate the concept of the impulse response function, Figure 2 plots for
this simulation experiment in the upper panel the time path of the disturbance
term u d and in the lower panel the path of the output variable. In the time
period prior to period t , there are no disturbances (both u d and u ms are set to
zero) and output is at its natural level, which in this simulation experiment is set
to zero. In period t , a unit innovation in u d occurs. Afterwards, no further
disturbances follow. 34 Due to the unit innovation in u d, t output increases in
period t by one unit. The response of output in the following periods shows
how long it takes for output to return to its natural level, if it does so at all.

__________
33 See also the discussion in Hamilton (1994), pp. 318.
34 The disturbance term u is set to zero throughout the experiment.
ms
 16

Figure 2: The impulse response function of output in response to an impulse in u d

ud

1 x

0 x x x x

t-2 t-1 t t+1 t+2 t

1 x
x
x
0 x x

t-2 t-1 t t+1 t+2 t

The system given by (15) is not yet identified. In the discussion of the general
identification problem it was shown that identification boils down to restricting
the elements in the matrix Q so that a unique structural model can be retrieved
from the data set. In the case of model (11) the matrix Q has four elements. Two
restrictions can be obtained from a suitable normalization of the model, which
 17

leaves two identifying restrictions to be imposed on the model. Since these

restrictions have not yet been imposed on the model, it follows that the impulse
response functions given by C do not have any economic meaning. In other
words, even though they show the response of the economy to the reduced form
disturbances u d and u ms , this is not particularly interesting because these
disturbances are devoid of economic content since they only represent a linear
combination of the underlying structural innovations ed and ems , given by
u t = Γ −1et . For the interpretation of the impulse response functions it would be
far more interesting to decompose the system (15) into

−1
(17) Yt = C ( L)Γ Γu t , or

(18) Yt = C ( L )et ,
*

with C * ( L ) = C ( L) Γ −1 containing the impulse response functions of the output

and money variable to the structural innovations ed and ems . The difference to
system (15) is that the innovations in e have an economic interpretation and,
therefore, the impulse response functions given by C* can be interpreted in a
meaningful way. For example, Cdms * would give the response of output to a
monetary policy shock, which is useful to understand the transmission
mechanism of monetary policy. However, the matrix Γ needs to be known in
order to compute C* , which returns the discussion to the familiar identification
problem.

II. Identification in the SVAR model

1. The orthogonality restriction

The identifying restriction that distinguishes the SVAR methodology from the
traditional dynamic simultaneous equation approach is the assumption in SVAR
models that the structural innovations are orthogonal, that is, the innovations ed
and ems are uncorrelated. Formally, this requires the variance-covariance matrix
 18

σ 2 0 
Σ e to have the form Σ e =  d  . In other words, the covariance σ dms is
 0 σ ms 
2

restricted to zero. Since the reduced form disturbance is linked to the structural
innovation by Γu = e , the reduced form and the structural variance-covariance
matrix are related to each other by ΓΣ u Γ' = Σ e . From this follows that the
orthogonality restriction imposed on Σ e leads to one non-linear restriction on Γ ,
thereby providing one of the two identifying restrictions needed here. 35
To explain the intuition behind the orthogonality restriction in SVAR models,
Bernanke (1986) writes that he thinks of the structural innovations „as
‘primitive’ exogenous forces, not directly observed by the econometrician,
which buffet the system and cause oscillations. Because these shocks are
primitive, i.e., they do not have common causes, it is natural to treat them as
approximately uncorrelated.”36 Bernanke continues to point out that this does
not imply that there is no contemporaneous correlation between the variables in
the structural model: “However one would not want to restrict individual u’ s
[structural shocks in his notation] to entering one and only one structural
equation, in general; thus the matrix A [here: Γ ] is allowed to have arbitrary off-
diagonal elements. Under this interpretation, then, the stochastic parts of
individual structural equations are allowed to be contemporaneously correlated
in an arbitrary way; however, the correlation between any two equations arises
explicitly because the equations are influenced by one or more of the same
fundamental shocks ut [here: et ]“. This discussion shows that the structural
innovations occupy a central place in the SVAR approach because they
represent the driving force behind the stochastic dynamics of the variables in the
model.
In the dynamic simultaneous equation approach to identification the structural
variance-covariance matrix Σ e usually remains unrestricted, because the
structural innovations have a fundamentally different role: They are interpreted
as errors in equations, reflecting minor influences on the determined variables

__________
35 See Faust (1998), pp. 6.
36 See Bernanke (1986), p. 52.
 19

by non-essential factors omitted from the determining variables of the

equations.37 That is, these errors merely represent the aggregate effects of a
large number of individually unimportant variables, and hence lack economic
significance. 38 Of course, from this standpoint of view it appears odd to use the
variance-covariance matrix of the structural innovations as a source of identify-
ing restrictions. However, in section 2 we saw that making assumptions about
the exogeneity of variables can also imply orthogonality restrictions,39 suggest-
ing that the differences between these two approaches may not be as pronounced
as it appears on first glance. 40

2. The normalization of the SVAR model

Before discussing the second identifying restriction, the normalization of the
SVAR model needs to be clarified. In dynamic simultaneous equation models,
the structural model is expressed in AR form, and the empirical analysis seeks to
obtain estimates of the parameter matrices Γ and B . In this framework it is
convenient to normalize the model by setting the diagonal elements of Γ to one,
 1 − γ1 
yielding Γ =   . In contrast to dynamic simultaneous equation models,
 − γ2 1 

SVAR models are based on the MA representation of the structural model, and
the empirical analysis seeks to estimate the impulse response functions given by
the matrix C * ( L ) . The impulse response functions are usually computed to show
the response of the model to a standard deviation shock to the structural
innovations. This makes it convenient to normalize the SVAR model by setting
the variances σd2 and σms
2
to one, because the standard deviation shocks, with
this normalization, correspond to unit innovations in e d and e ms respectively.
__________
37 For a detailed discussion see Qin and Gilbert (2001), pp. 430.
38 See Qin and Gilbert (2001), p. 425.
39 The assumption of an exogenous money supply in our bivariate structural model implies
that the two structural innovations are orthogonal.
40 For a detailed discussion of this point see Leeper et al. (1996), pp. 9.
 20

From this follows that the variance-covariance matrix of the structural

 1 0
innovations is assumed to have the form Σ e =   , or, in brief, Σ e = I .
 0 1
It needs to be emphasized that the normalization is only about the scaling of
the system and nothing of substance is altered here. Technically speaking, with
the structural innovations related to the reduced form disturbances by e = Γu , the
matrix Γ is normalized so that ΓΣ u Γ ' = Σ e = I is obtained. In dynamic simultane-

ous equation models the diagonal elements of Γ are set to one, which happens to
be just another transformation of Γ .

3. Restrictions on the matrix Γ

Having normalized the model, the discussion now returns to the identification
issue. By imposing the orthogonality restriction and the normalization, we have
restricted the variance-covariance matrix of the structural innovation to the form
Σ e = I . Since the reduced form variance-covariance matrix is given by
Σ u = Γ − 1Σ e Γ − 1 ' , this simplifies now to Σ u = Γ − 1Γ − 1 ' . There are three distinct
elements in Σ u , which have been estimated in the first step of the SVAR
procedure. The matrix Γ −1 Γ −1 ' has four elements, so we require one more
restriction to identify the model. Exclusion restrictions are imposed on the
matrix Γ for this purpose, just as is done in traditional dynamic simultaneous
equations models.
But there is a subtle difference in the interpretation of these restrictions in the
context of SVAR models, because the matrix Γ has a different role. In dynamic
simultaneous equations models this matrix models the contemporaneous
relationships between the variables in the model, whereas in SVAR models it
models the contemporaneous relationship between reduced form disturbances.
The reason for the reinterpretation of Γ is that SVAR models aim to identify the
structural innovations e in order to trace out the dynamic responses of the
model to these shocks, which yields the impulse response functions. To this end
the SVAR model focuses on the relation Γut = et , and identifies the structural
innovations by imposing suitable restrictions on Γ . In other words, in SVAR
 21

models the dynamic relationships in the economy are modeled as a relationship

between shocks.
To show how the ‘shock view’ characteristic for SVAR models is related to
the conventional AR representation of the structural model, we take the
structural model given by (11) as a starting point. 41 Imposing the orthogonality
restriction on (11) yields the following model,

(19) ΓYt = B( L)Yt + et ,

where the vector e contains the structural shocks and the variance-covariance
matrix has the form Σ e = I . Next, we subtract from each side of equation (19)
the expected value of Yt implied by the model, conditional on the information
available in time t − 1 , Et −1Yt . Beginning with the term on the left hand side,
according to (13) the information on Yt available in time t − 1 is summarized in
the term B * ( L )Y t , implying that the forecast error Yt − Et −1Yt is equal to the
reduced form error ut . Regarding the right hand side of equation (19), the term
B( L)Yt contains only variables known at time t − 1 and therefore drops out,
leaving only the structural innovations et which cannot be forecasted. This
yields the familiar relationship,

(20) Γut = et .

To summarize, the ‘shock view’ is obtained by removing all those components

from the structural model that are expected at t − 1 . By focusing on the relation
given by (20) SVAR models concern themselves only with modeling the
unexpected changes in Yt . This represents a considerable departure from the
traditional modeling practice, because dynamic simultaneous equations models
do not make a distinction between expected and unexpected changes in Yt in the
first place. 42
To show the implications of the ‘shock view’ for the interpretation of the
restrictions imposed on the matrix Γ , we consider the identification of a
monetary policy shock. There are essentially two sets of restrictions that are
__________
41 The following presentation is based on Clarida and Gertler (1997), pp. 380.
42 See also Bagliano and Favero (1998), pp. 1071.
 22

widely used in the SVAR literature to identify the monetary policy shock.43 One
approach is based on the assumption that the central bank cannot respond
instantaneously to developments in the real economy. 44 Imposing this restriction
on (20) yields

 γ 11 γ 12  u y , t   ed , t 
(21)   =  .
 0 γ 22  ums, t   ems, t 

It is apparent from (21) that this restriction imposes a recursive order on the
reduced form disturbances; contemporaneous causality is restricted to run from
the money disturbance ums to the output disturbance u y but not into the other
direction. 45 This implies that an aggregate demand shock, which corresponds to
an innovation in ed , t , leads within the period to a forecast error in the output
variable, but not in the money supply variable, because the central bank does not
realize that this shock occurs and, therefore, fails to adjust the policy instrument
accordingly.
When we discussed the identification of dynamic simultaneous equation
models with the help of exclusion restrictions on the matrix Γ we considered a
similar restriction (γ 2 = 0 ). Writing the model given by (7) and (8) in matrix
form and restricting the parameter γ 2 to zero we obtain

 1 γ 1  yt   Byy ( L) B ym ( L)  yt   ed , t 
(22)    =    +  .
 0 1  t  
m Bmy ( L ) B mm ( L )  t   ms, t 
m e

__________
43 See also the discussio n in Bernanke and Blinder (1992), p. 902.
44 As argued in section 2, this assumption is motivated by lags in the collection and publica-
tion of statistics for many macroeconomic variables, which make it impossible for the
central bank to observe these variables within the period. This assumption, of course, is
only plausible for models based on monthly or quarterly data, but is not suitable for
models using annual data.
45 The other approach proposes just the other direction of causality by assuming that real
activity variables only respond with a lag to a policy innovation. For our bivariate model
this means that output does not respond instantaneously to a monetary policy shock. For
the SVAR model, this approach suggests to restrict the parameter γ12 to zero. In the
simultaneous equation model discussed in section 2 this is equivalent to restricting the
parameter γ1 to zero.
 23

The matrices Γ in (21) and (22) are practically identical. 46 Nevertheless, they
differ in their interpretation. In the simultaneous equation model the restriction
on Γ implies that a change in the output variable, regardless whether it is
expected or not, does not affect the money supply within the period. This is a
considerably stronger assumption than that imposed on the SVAR model.
Put another way, in the simultaneous equation model the equation for the
money variable is interpreted as a central bank reaction function, showing how
the central bank sets the money supply in response to current and past output,
without making a distinction between expected or unexpected changes in output.
The equation for the money variable in the SVAR model can also be interpreted
as a reaction function of the central bank, albeit as a ‘reaction function in
surprises’, as Clarida (2000) puts it. This equation models unexpected changes
in the policy stance, ums,t , as a function of unexpected changes in output, u y , t ,
and of unexpected discretionary policy actions, which are represented by the
monetary policy shock ems, t .
Up to now we have discussed only exclusion restrictions on the matrix Γ . In
our bivariate model an exclusion restriction on Γ automatically imposes a
recursive order on the system. This is called a Choleski decomposition. In
applied work the Choleski decomposition is fairly popular, because it is easy to
handle econometrically. 47 Nevertheless, the Choleski decomposition represents
just one possible strategy for the identification of a SVAR model and should
only be employed when the recursive ordering implied by this identification
scheme is firmly supported by theoretical considerations. Alternatives include
non-recursive restrictions on the matrix Γ .48 Besides the restrictions on
contemporaneous interactions it is also possible to impose long-run restrictions
on the effects of structural shocks.49 Finally, it is also possible to combine
contemporaneous and long-run restrictions.50 With the help of econometric
__________
46 The elements on the diagonal of Γ differs, but this reflects only the different normaliza-
tions of the two models.
47 See Enders (1995), pp. 302.
48 These have been introduced by Bernanke (1986). For another application see Blanchard
(1989).
49 The seminal article in this context is Blanchard and Quah (1989).
50 This has been introduced by Gali (1992).
 24

programs like Malcolm or EViews all these identification schemes can be

implemented fairly easily. 51

4. Identification in SVAR models compared to the traditional approach

to identification

The approach to identification in SVAR models is designed to avoid the

problems in dynamic simultaneous equation models which often lead to
‘incredible’ identifying restrictions, as Sims (1980) puts it. One of the major
problems in the traditional approach to identification is the difficulty of finding
truly exogenous variables that can be used as instruments. This is particularly so
in the field of monetary economics, because practically every variable in the
monetary/financial sector is to some extent endogenously determined given well
established financial markets and rational expectations. Moreover, for the same
reasons it is hard to justify on a priori grounds that a given variable has no
influence on another variable. That is, there are hardly any compelling identify-
ing restrictions.
In response to these difficulties, SVAR models treat all variables as
endogenous. The sampling information in the data is modeled with the help of
VAR models, which model each variable as a function of all other variables.
Regarding the identifying restrictions, SVAR models first decompose all
variables into their expected and unexpected parts. The identifying restrictions
are then imposed only on the unexpected part, where plausible identifying
restrictions are easier to find.
With respect to monetary policy, the SVAR approach recognizes that the
policy instrument is for the most part endogenously determined, which
precludes treating this variable as exogenous. Having modeled the reduced form
of the model with the help of a VAR system, the SVAR analysis proceeds to
identify the model. To this end a ‘reaction function in surprises’ is modeled,
which expresses unexpected changes in the policy instrument as a function of
unexpected changes in the non-policy variable and of monetary policy shocks.
The objective is to identify the monetary policy shocks from this relation, which
__________
51 See Keating (1992) for a discussion on the different modeling strategies within the SVAR
framework.
 25

represent the discretionary component of policy, or, according to Bagliano and

Favero (1998), the deviation of policy from the rule. 52 The two authors justify
the focus on shocks in SVAR models as follows: “the focus is not on rules but
on deviations from rules, since only when central banks deviate from their rules
it becomes possible to collect interesting information on the response of
macroeconomic variables to monetary policy impulses, to be compared with the
predictions of the alternative theoretical models.”53 To identify the monetary
policy shocks in our example, we imposed the restriction that monetary policy
makers cannot observe unexpected changes in output within the period. Since
this restriction is based on the observation that there is a lag in the collection of
statistics, this assumption is fairly unrestrictive. It is also much more plausible
than the corresponding restriction in dynamic simultaneous models stating that
monetary policy makers do not respond to output movements within the period
regardless whether they expect this movement or not.
However, these advantages comes with a price. First, even though the
restrictions imposed on the matrix Γ may not be particularly restrictive, the
SVAR methodology requires, in contrast to simultaneous equation models, the
structural innovations to be orthogonal, which is a fairly restrictive assumption,
as we will see below. Second, even though the ‘shock view’ of the SVAR
approach is well suited to investigate the dynamics of a system by subjecting it
to an unexpected shock, the question how the system responds to an expected
change in a variable remains unanswered. This issue is taken up in the following
section in more detail.

III. Dynamic multipliers versus impulse response functions

In section 2 we discussed modeling the effect of monetary policy on output

using a dynamic simultaneous equation model. Based on estimates of the
parameters γ 1 , Byy (L) and B ym ( L) this approach allows us to compute the
dynamic multipliers of output which describe the impact of the policy
instrument on output. Alternatively, we can investigate the effects of monetary
__________
52 See Bagliano and Favero (1998), p. 1074.
53 See Bagliano and Favero (1998), p. 1074.
 26

policy using a SVAR model, and obtain an impulse response function showing
how output responds to a monetary policy shock.
It is tempting to interpret impulse response functions in a similar manner as
dynamic multipliers.54 In particular, we may be tempted to use impulse response
analysis to shed some light on the issue of how long it takes until a change in the
monetary policy stance reaches its full effect on output, which is an important
issue in applied business cycle analysis. But impulse response analysis is
unlikely to be helpful in this regard, because most monetary policy actions
represent a systematic response of the central bank to the state of the economy
and do not come as surprises. That is, most monetary policy actions are not
monetary policy shocks. It is therefore important for applied business cycle
research to know what the output effects of systematic monetary policy are,
while the output effects of unanticipated, discretionary monetary policy are only
of secondary interest. But impulse response analysis only says something about
the latter aspects, and remains largely silent on the output effects of systematic
and hence anticipated monetary policy. Dynamic multipliers, on the other hand,
are useful in investigating the output effects of a change in the policy stance
even when the new policy stance has been widely expected because dynamic
multipliers give the impact of the policy instrument on output without
distinguishing between expected and unexpected monetary policy. 55 This means
that dynamic multipliers can be employed, for example, to determine the values
to be assigned to the policy instrument to achieve a given output path.
The difference between dynamic multipliers and impulse response functions is
also a reflection of the fact that dynamic simultaneous equation models and
SVAR models are designed for different tasks.56 In the field of monetary
economics dynamic simultaneous equation models are primarily used for policy
simulation, whereas SVAR models are used for the analysis of the monetary
transmission mechanism. The shock analysis conducted in SVAR models is the
closest approximation of a controlled experiment available in empirical eco-
nomics. Once the monetary policy shock is identified, one can see the monetary
__________
54 For a detailed discussion of this issue see Cochrane (1998).
55 See Bagliano and Favero (1998), pp. 1071.
56 This point is emphasized by Bagliano and Favero (1998), p. 1072.
 27

transmission mechanism unfold by observing the response of the non-policy

variables to this monetary impulse. The issue of reverse causality which usually
plagues the analysis of dynamic relationships is not an issue in SVAR models,
because by tracing out the dynamics of the system to an unexpected shock the
causality is pinned down and runs unambiguously from the monetary policy
shock to the other variables in the model.
This kind of structural inference is not possible using the conventional reduced
form analysis of the lead/lag structure, which is often employed as an alternative
tool to investigate the transmission mechanism. For example, a cross correlo-
gram may show that money leads output in time, but one cannot conclude from
this finding that money is causal for output. 57 The reason for this is that it is
very possible that the monetary authority anticipates future movements in output
and sets the contemporaneous money supply accordingly. In this case causality
actually runs from output to money, even though money leads output in time. 58
The results from the SVAR analysis are more reliable in this respect, because
the simulation experiment is designed to rule out this problem.
Another important advantage of SVAR models in the analysis of the monetary
transmission mechanism is that the identifying restrictions imposed on these
models are in many instances quite general and therefore are compatible with a
wide spectrum of alternative theories.59 For instance, identifying restrictions are
often based on relative uncontroversial assumptions about the minimum lag of
the responses of macro variables to monetary impulses, or they are derived from
the institutional context. An example of the latter is the restriction employed in
the preceding sections that the central bank cannot observe contemporaneous
output due to lags in the collection of the relevant statistics. The use of restric-
__________
57 The classic example to illustrate the fallacy of interpreting correlation as proof of causality
is that of sales of ant i- freeze fluid and winter. For a discussion of this issue see Hamilton
(1994), pp. 305.
58 Proponents of the Real Business Cycle school use this line of argument to explain the
stylized fact that money leads output in time, while maintaining that output mo vements
are due to real shocks and not to monetary policy actions. More precisely, with cash- in-
advance constraints producers have to accumulate money balances first before they can
expand production in response to a (positive) real shock. This leads to the observed
correlation between money and output, even though monetary policy plays only a passive
role.
59 See Bagliano and Favero (1998), p. 1074.
 28

tions compatible with a large number of theories allows to employ the SVAR
methodology to discriminate between competing theories.60
To summarize, impulse response functions are an useful tool for the analysis
of the monetary transmission mechanism, but they are less suited for the
analysis of the effects of systematic policy or for policy simulation. In principle,
SVAR models can also be employed for the latter task, but this requires
modifications to the conventional impulse response analysis which are not yet
standard in econometric software programs like Malcolm or EViews.61

D. Objections to the SVAR methodology

The SVAR methodology has become a popular but controversial tool for the
analysis of the monetary transmission mechanism and business cycle fluctua-
tions. This section reviews the main challenges to the SVAR approach. These
can be grouped into three categories: First, many observers have doubts on the
role of shocks in SVAR models. Particular in monetary economics it is
questionable whether the estimated monetary policy shocks are truly measuring
a relevant part of central bank behavior. Second, there is concern that the
widespread use of informal restrictions in SVAR models may give rise to
undisciplined data mining. This raises the broader question of what can be
learned from these models if they reflect, due to the informal restrictions, largely
the prejudice of the modeler. Third, the orthogonality restriction is a major
source of concern.

I. What do the shocks mean?

The SVAR approach to analyzing the monetary transmission mechanism is often

criticized on the grounds that it supposedly suggests that central banks operate
as ‘random number generators’. 62 Since hardly any monetary authority wishes
__________
60 For an application see, for example, Sims (1992).
61 For the analysis of systematic monetary policy using SVAR models see Cochrane (1998),
Bernanke et al. (1997), Sims (1999) and Gottschalk and Höppner (2001).
62 See the discussion in Bernanke and Mihov (1996) on this issue.
 29

to randomize its decisions, any error is likely to be quickly reversed. This raises
the question of how the monetary policy shocks in SVAR models are related to
central bank behavior and how they could be large enough to matter. Regarding
the second issue, it should be noted that SVAR models use monetary policy
shocks to trace out the dynamics of the model and, for this purpose, the shocks
need neither be large nor persistent. Nevertheless, the economic interpretation of
these shocks remains an open question.
Bernanke and Mihov (1996) argue that „policy shocks can be generated from
two realistic sources: (a) imperfect information on the part of the central bank
about the current economy, and (b) changes in the relative weights put by the
central bank on moderating fluctuations in output and inflation.“63
The first source of monetary policy shocks refers to measurement errors
caused by lags in the collection of data and frequent data revisions. The central
bank can observe the true state of the economy and reverse policy actions due to
measurement errors only after final data has become available. These policy
errors due to measurement error can be identified by estimating the equation for
the policy instrument in the VAR, which represents the policy rule, with revised
data, that is, data that was not known contemporaneously to the monetary
authority. With the policy rule based on revised data all policy actions due to
misperceptions of the true state of the economy show up in the SVAR model as
deviations from the policy rule, which are then interpreted as monetary policy
shocks.64
The second source of shocks refers to the decision making process within the
central bank. The members of the central bank committee in charge of setting
the money supply are likely to have different preferences regarding the relative
weights to be put on the stabilizing output or on the adherence to the inflation
target. As a consequence, the decision making process itself may follow a
random process, depending on shifts within the committee. In this case the
random part of the reaction function corresponds to the random fluctuations in
central bank preferences. Thus, these random fluctuations become a useful

__________
63 See Bernanke and Mihov (1996), p. 34.
64 For a critical view of the role of measurement error as a source for policy shocks see
Rudebusch (1998) pp. 918.
 30

source of monetary policy shocks that can be used to identify the effects of
monetary surprises on macro variables.
If monetary shocks are mainly due to measurement error or to the random
component in the decision making process, this suggests that they are unlikely to
be an important source of business cycle fluctuations. Bernanke and Mihov
(1998) write: „The emphasis of the VAR-based approach on policy innovations
arises not because shocks to policy are intrinsically important, but because
tracing the dynamic response of the economy to a monetary policy innovation
provides a means of observing the effects of policy changes under minimal
identifying assumptions.“65

II. Do the SVAR measures of monetary policy shocks make sense?

Closely related to the issue of the meaning of shocks is a provocative question

raised by Rudebusch (1998): „Do the VAR interest rate shocks make sense?“.
He argues that the estimates of the impulse response functions are only reliable
if the VAR measure of the policy shocks are accurate proxies of the ‘true’ policy
shocks. To shed some light on this, he computes a series of unanticipated policy
shocks based on forward-looking financial market time series as a benchmark
for the VAR measure of the policy shocks. He finds the Federal funds future
contract series to be an unbiased predictor of the Federal funds rate. His measure
of the unanticipated policy shocks is the forecast error of this financial market
series with respect to the actual Federal funds rate. Assuming that the financial
markets accurately measure policy shocks, Rudebusch proceeds to show that
movements in the ‘true’ shocks account for only about 10 to 20 percent of the
variation in a monetary policy shock series obtained from a standard SVAR
model. In addition he shows that monetary policy shocks obtained from different
SVARs are only weakly correlated. Following Rudebusch’ s logic these results
cast a dim light on the reliability of impulse response functions obtained from
SVAR models.
This line of reasoning has not remained unchallenged. Sims (1998) points out
that it is a main point of the VAR literature that „there is no reason in principle
__________
65 See Bernanke and Mihov (1998), p. 872.
 31

to assume that unforecastable changes in the federal funds rate are policy
shocks.“66 This puts a question mark behind the claim by Rudebusch that his
forecast error series based on future contracts is an adequate measure of the
‘true’ monetary policy shocks. In the SVAR literature the reduced form
disturbances to the Federal funds rate equation correspond to forecast errors,
but, as pointed out by Sims, these are not the policy shocks used as instruments
in the SVAR methodology. After all, obtaining the policy shocks from the
reduced form errors is exactly what identification is about. This suggests that
Rudebusch’ s measure remains silent on one of the most important issue in the
SVAR approach, namely the identification of shocks. His series is comparable
with the reduced form shocks but not with the policy shocks of interest. In this
context it is also not particularly surprising that different identification schemes
yield different histories of the policy innovations, so that the correlation between
policy shocks derived from SVAR models is rather low.
This goes some way to answer the criticism of Rudebusch, but an important
issue remains unresolved: Rudebusch shows that the reduced form errors of the
VAR interest rate equation are also only weakly correlated with his measure,
which suggests a poor forecast performance of the VAR compared to the future
rates that are probably quite close to being efficient predictors. As he notes, „it is
hard to imagine that one could get the unanticipated shocks wrong [the reduced
form disturbances], but still get the exogenous unanticipated shocks [the
structural shocks] right.“67
There are essentially three counter-arguments. First, Sims (1998) notes that
forecast errors for the monetary policy instrument are due to two sources,
namely on the one hand surprises in private sector variables relevant for central
bank behavior and on the other hand the monetary policy innovation. The VAR
literature seeks to identify the latter. If the financial markets are really good at
forecasting monetary policy behavior, then the forecast error of future contracts
embodies mainly the first source, which would make them worse measures of
the ‘true’ monetary policy shocks than the VAR errors, which contain both
sources.
__________
66 Sims (1998), p. 937.
67 See Rudebusch (1997), p. 920.
 32

Second, Kuttner and Evans (1998) show that quantitatively small deviations
from perfect futures market efficiency create a significant downward bias in the
correlation metric employed by Rudebusch. They conclude that the correlation
between VAR residuals and futures-market shocks is probably a poor measure
of the VAR’s performance.
Third, Bagliano and Favero (1998) compare the monetary policy shocks
derived from a VAR with three alternative measures obtained from direct obser-
vation of financial market behavior. The authors apply the same identification
scheme to all four series, which allows them to compute the impulse response
functions for the different policy shock measures. They find that „despite of the
not very high correlation between the benchmark VAR and the alternative
measures of monetary policy shocks, the descriptions of the monetary transmis-
sion mechanism obtained by impulse response functions estimated are not sub-
stantially different from each other.“68 To summaries, while Rudebusch initiated
a fruitful discussion, it appears the SVAR approach withstands this criticism so
far.69

III. The use of informal restrictions in the identification of shocks

Another objection to the SVAR approach concerns the use of informal restric-
tions. These are indeed widespread; most researchers will have some idea how
the impulse response functions to a given structural innovation should look like.
For instance, with regard to the monetary policy shock a widely held view is that
an increase in the money supply should lead to a temporary decrease in the short
interest rate, in addition this shock should trigger a positive but temporary
output response followed by a sluggish but lasting increase in the price level.
Having imposed the formal identifying restrictions, many SVAR modelers
check in a next step whether the estimated impulse response functions are in
__________
68 See Bagliano and Favero (1998), p. 1111.
69 Besides raising the question whether the VAR’s policy shocks make sense Rudebusch also
questions whether the VAR interest rate equations are reasonable. However, the issues he
discusses like the choice of a time- invariant, linear structure, the scope of the information
set or the long distrib uted lags are not particular to VAR models; any reasonably specified
empirical model should pay attention to these issues. For a discussion in the VAR context
see again Sims (1998) or Bagliano and Favero (1998).
 33

accordance with their a priori views. If they find implausible responses, usually
the researcher returns to the specification of his model and examines whether it
is possible to come up with a more plausible model. This kind of procedure
leads to the charge that SVAR analysis is prone to undisciplined data mining.
Leeper et al. (1996) respond to this by pointing out that the use of informal
restrictions „differs from the standard practice of empirical researchers in
economics only in being less apologetic. Economists adjust their models until
they both fit the data and give ‘reasonable’ results. There is nothing unscientific
or dishonest about this. It would be unscientific or dishonest to hide results for
models that fit much better than the one presented (even if the hidden model
seems unreasonable), or for models that fit about as well as the one reported and
support other interpretations of the data that some readers might regard as
reasonable.“70
Nevertheless, since informal restrictions are often not made explicit some care
is warranted when interpreting impulse response functions. Uhlig (1999) argues
that otherwise some degree of circularity may arise in the way conclusions are
drawn from the SVAR literature. For instance, consider the frequent finding in
the SVAR literature that there are no long-run effects of monetary policy shocks
on output. It is tempting to conclude that this proves conclusively the notion that
money is neutral in the long-run. However, this line of reasoning is likely to
suffer from circularity, because the long-run neutrality of money is exactly of
one of those restrictions that it is frequently used either formally or informally to
specify the SVAR model in the first place.
Related to the issue of informal restrictions is the question of whether the
SVAR methodology is a suitable tool to establish stylized facts in order to
discriminate between different theoretical models. Even though the formal
identifying restrictions may be weak enough to be compatible with a number of
theories, the presence of informal restrictions makes it almost unavoidable that
the impulse response functions reflect at least to some degree the preconceived
ideas of the modeler about the dynamics of the system. 71 This puts some doubt
__________
70 See Leeper et al. (1996), pp. 5.
71 Faust (1999) and Uhlig (1999) both propose procedures which formalize common
informal restrictions for the shape of impulse response functions, which is a useful step to
enhance the transparence and to investigate the robustness of SVAR results.
 34

on the claim that impulse response functions are as impartial as the more
traditional cross-correlation statistics when it comes to establishing stylized
facts.

IV. What are SVAR models good for?

The preceding discussion may raise the question of what impulse response
functions are actually good for when they reflect as much the prejudices of the
modeler as the sampling information in the data. As regards this point, it needs
to be emphasized that SVAR models are structural models - after all, this is what
the S stands for. Therefore, they are intended to represent a ‘true’ model of the
economy. Since the sampling information alone does not reveal what the ‘truth’
is, some a priori held views have to be imposed to identify the empirical model.
This holds for every structural macroeconometric model. That is, any structural
model, be it an SVAR or a simultaneous equations model, reflects the prejudice
of the modeler to some degree.
Structural modeling always means that one has to take a stand on the way the
economy works. From this standpoint of view the identifying restrictions are
derived, and finally the corresponding empirical model is estimated. Having
done this, one can test overidentifying restrictions to investigate those aspects of
the theoretical model that have not been imposed a priori on the empirical
model. This modeling strategy is, for instance, neatly summarized by the title
chosen by Gali (1992) for his seminal paper „How Well Does the IS-LM Model
Fit Postwar US Data?“. In this paper Gali takes the IS-LM model as the starting
point, imposes the corresponding identifying restrictions on the data and
proceeds to check whether the unrestricted aspects of the empirical model
conform with the underlying theoretical model. He finds that his model fits the
data quite well, which, of course, falls well short of claiming that his model is
the ‘true’ model, because nothing is said about the ability of competing models
to fit the data. They might do so as well or even better.
The modeling strategy implemented by Gali shows that it is a strength of the
SVAR framework that it allows it to explore what exactly a given theoretical
view implies for the dynamic linkages in an empirical model which has been
identified on this basis. The dynamic linkages are represented in the form of
 35

impulse response functions, which are easy to interpret. In addition it is possible

to quantify the role of the individual structural shocks for the variability of the
variables in the model. For instance, Gali presents a historical decomposition of
the output series, which links different business cycle episodes to specific
shocks hitting the economy.
To summarize, the SVAR approach is useful to explore what a given
theoretical view implies for the dynamic behavior of the variables of interest.
Or, as Breitung (1998) puts it, SVAR model are useful to take a theory guided
look at the data. 72

V. The orthogonality restriction

A major objection to the SVAR methodology concerns the orthogonality restric-

tion for the structural shocks. As has become apparent, this restriction is central
for the SVAR identification approach. To illustrate the potential problems with
the orthogonality assumption, we consider the bivariate model comprised of the
unemployment rate and the growth rate of output. This model has been
popularized by Blanchard and Quah (1989), who identify a demand and a supply
shock with the help of the restriction that a demand shock cannot have long-run
effects on the level of output. This model has become a standard tool in the
analysis of the sources of business cycle fluctuations.
The problem with the model proposed by Blanchard and Quah is that even
though it is in accordance with simple textbook versions of the macroeconomy,
the system’s low dimension proves to be highly restrictive when seen in the
context of the more elaborate theoretical models where there are more than two
shocks. Blanchard and Quah recognized this potential weakness and derived the
conditions under which this approach may still lead to meaningful results. The
starting point of their analysis is the assumption that the economy is driven by m
shocks, but each shock is either a supply or a demand shock. This is still quite
restrictive, because it implies that all shocks can be classified as belonging either
to the one group or to the other. It also implies that all supply disturbances have
permanent output effects, while all demand disturbances have only a transitory
__________
72 See Breitung (1997), p. 389.
 36

effect on output. The two authors demonstrate that this additional assumption is
not sufficient to prevent the commingling of shocks, i.e. the identified shocks
are likely to be a mixture of both underlying shocks. In their final step, they
proceed to prove that the commingling of shocks is avoided when the dynamic
relationship between output and unemployment remains the same across
different supply disturbances, with the same result holding for all demand distur-
bances. The authors note that this is highly plausible for demand disturbances,
but not for supply disturbances.
This analysis has recently been extended by Faust and Leeper (1997). In
addition to the issue of the commingling of shocks, Faust and Leeper ask under
what conditions the timing of shocks will not be distorted. They point out, for
instance, that even when the identified aggregate demand shock involves only
the ‘true’ demand shocks, the SVAR identification procedure may still fail to
preserve the timing of the shocks in the sense that the ‘true’ dynamic response of
the economy to any particular demand shock will differ from the estimated
response of the economy to the identified aggregate demand shock. To put it
differently, since the average response of output to demand disturbances is not
particular informative for a number of purposes, it is well worth asking under
what conditions the estimated output response corresponds exactly to the effects
of the ‘true’ demand shocks.73 Faust and Leeper (1997) show that preserving
both the categories of the shocks and the timing of the responses requires “that
each underlying shock of a given type affects the economy in the same way up
to a scale factor.”74 The intuition behind this result is simple: Since the
empirical analysis yields only one output impulse response function to a demand
disturbance, this one demand response could have preserved the timing of the
different ‘true’ demand disturbances only if those shocks all affect output in

__________
73 For instance, the estimated output response to an aggregate demand response is of little
help when the effects of a foreign demand shock are of interest. The problem is that under
the conditions outlined by Blanchard and Quah to avoid the commingling of shocks the
estimated aggregated demand response represents the average of the output response to
diverse demand shocks and there is no way of disentangling the response of output to the
foreign demand shock, which is of interest here.
74 See Faust and Leeper (1997), p. 349.
 37

essentially the same way. 75 The two authors point out that this is implausible in
most cases.
The problem with the low dimension of the bivariate models becomes even
more serious when one does not believe that there are only two groups of fun-
damental shocks. A shock to the nominal exchange rate, for example, has effects
both on the supply and demand side of the economy; therefore, this shock is not
easily classified as belonging only to one or to the other group, but should be
modeled as a distinct shock. Seen from this standpoint, the orthogonality
restriction, which is based on the assumption that there are only two fundamen-
tal sources of shocks, becomes rather difficult to justify. 76
Given that it is impossible to identify three structural shocks using a bivariate
model, this would suggest to turn to larger systems. However, there are limits to
this, because the number of restrictions required for identification increases
rapidly with the size of the system. Garratt et al. (1998), for example, consider
an eight variable model, which implies the need of 28 restrictions to exactly
identify the impulse response functions. In this context, they note that „it is not
clear how these restrictions could be obtained, let alone motivated from an
appropriate economic theory perspective.“ Also, the number of underlying
structural disturbances in their theoretical model is considerably larger than the
number of reduced form disturbances, which alone precludes the orthogonaliza-
tion of the variance-covariance matrix. Instead they compute so called ‘Gener-
alised Impulse Responses’, which give the time profile of the effects of a unit
shock to a particular equation on all the endogenous variables. The advantage of
this procedure is that it does not require the orthogonalization of shocks. The
disadvantage is that no economic interpretation is given to the shock. Rather,
these shocks are thought of as representing those typically observed in the past,
but this vagueness makes the interpretation of the ‘Generalised Impulse
Responses’ quite hard.
This discussion suggests that the orthogonality restriction is likely to be a very
restrictive assumption in most cases. However, the SVAR methodology is not
__________
75 The scaling does not affect the shape of the impulse response function.
76 If there are indeed three types of fundamental shocks, the two structural shocks identified
in the bivariate framework are likely to represent linear combinations of these three shocks
and there is no reason to expect them to be orthogonal.
 38

alone with this problem, because the assumption of an exogenous money supply
in the traditional approach to identification was shown in section 2 to imply also
the assumption that the structural innovations are uncorrelated.77 This usually
remains unnoticed because in our example it was sufficient to estimate only the
output equation to identify the parameters in the aggregate demand relation. In a
SVAR model, on the other hand, both the output and money equations are
estimated. The imposition of the orthogonality restriction leads in the SVAR
methodology to an explicit restriction on Γ so that this matrix fulfills the
condition ΓΣ u Γ' = Σ e . This is not the case in the traditional approach, because
there the reduced form variance-covariance matrix Σ u does not enter the
considerations in the first place. Leeper et al. (1996) notice in this context: „ In
practice, traditional SE [simultaneous equations] approaches often focus on the
equations and treat the rest of the stochastic structure casually.“78 Moreover,
Leeper et al. point out that the correlation among disturbances is a serious
embarrassment when a model is used for policy analysis, as is often the case
with dynamic simultaneous equations model. They write: “If disturbances to the
monetary policy reaction function are strongly correlated with private sector
disturbances, how can one use the system to simulate the effects of variations in
monetary policy? In practice, the usual answer is that simulations of the effects
of the paths of policy variables or of hypothetical policy rules are conducted
under the assumption that such policy changes can be made without producing
any change in the disturbance term in other equations, even if the estimated
covariance matrix of disturbances shows strong correlations.”79 Seen in this
light it is an advantage of the SVAR methodology that it treats the stochastic
structure of the model explicitly.

__________
77 See also the discussion in Leeper et al. (1996), pp. 9.
78 See Leeper et al. (1996), p. 9.
79 See Leeper et al. (1996), p. 9.
 39

E. Conclusion

The discussion in this paper has shown that a SVAR models are a useful tool for
analyzing the dynamics of a model by subjecting it to an unexpected shock.
Since the identifying restrictions are often compatible with a wide spectrum of
alternative theories the SVAR methodology is frequently employed to investi-
gate the monetary transmission mechanism. However, since informal restrictions
play an important role in the practice of SVAR modeling, this methodology is
less capable to discriminate sharply between competing theories, but rather
allows a theory guided look at the data. Another application includes the analy-
sis of the sources of business cycle fluctuations. The ability of SVAR models to
attribute a specific business cycle episode to the occurrence of demand or supply
(or other) shocks is presumably of considerable value for applied business cycle
research.
The discussion in the preceding section has also shown, however, that the
orthogonality restriction, which is fundamental to identification, is likely to be a
fairly restrictive assumption due to the low dimension of many SVAR models.
As a consequence, the commingling of shocks is an issue. This means that an
identified demand shock, for example, is comprised of ‘true’ demand shocks and
other underlying shocks. This puts a question mark behind the reliability of the
results of SVAR models. Nevertheless, even though this suggests characterizing
this methodology as useful but not particular reliable, this puts the SVAR
models into good company, because a similar judgment is likely to hold for most
econometric methods, particularly for dynamic simultaneous equation models.
 40

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