Structural Vector Autoregression (SVAR) modelling basics I - Applied Econometrics

 ■ SVAR (Seld made notes: Reference to IMF reports)

The question may trigger in our mind tha why we need the SVAR? 

Say, we want to know the the affects of the monetary policy in the economy.

So for this let us consider the set of events: 

a) Central bank anticipates an increase in inflation.

b) The central bank increases the monetary policy interest rate, but inflation still rises as anticipated.

Now here, one could wrongly conclude that the interest rate hike led to the rise in the inflation.

However, it was endogenous reaction to expected inflation (monetary policy contraction was endogenous).

Monetary policy reacted to the expected inflation. So, these events reflect the cobtrary to the impact of inflation expectations on the monetary policy.

But in actual sense this is not what we are wanting to measure. Here, we can't say that the impact policy has on the other variables. Simply, this is not the correct way to measure the effects of the monetary policy.

The similar problem applies with the fiscal policy as well.

Suppose, we want to know the effects of fiscal spending on the economy, so let's consider new sequence of the events.

The fiscal authorities anticipate a reduction in private demand and then increase pubkic spending causing an increase in the deficit while total output continues declining for some time.

Say, the wrong conclusion would be the spending multiplier is negative or in other words that the spending hike reduced output. So in actual sense, the fiscal reaction was endogenous. The Fiscal policy reacted to the expected output development.

So, this is not again the way of measuring tge effects of public spending on the economy. So, we can't measure the impact of monetary or fiscal policy when the policy variable is reacting to the movemens of the other variables is reacting to the movements of the other variables. 

In order to measure the effects of the policywhat we really want is to identify or to isolate purely exogenous, purely independent movement or shocks to the variable of the interest and see how the economy reacts to them which is known as the input responses.

Here we want to identify totally exogenous monetary policy rate and to fiscal  spending respectively.

To do this we have to identify the SVAR.

To be contd...

Thank You

Aditya Pokhrel

MBA, MA Economics, MPA