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External Instrument SVAR Analysis for Noninvertible Shocks

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We propose a novel external-instrument SVAR procedure to identify and estimate the impulse response functions, regardless of the shock being invertible or recoverable. When the shock is recoverable, we also show how to estimate the unit variance shock and the `absolute' response functions. When the shock is invertible, the method collapses to the standard proxy-SVAR procedure. We show how to test for recoverability and invertibility. We apply our techniques to a monetary policy VAR. It turns out that, using standard specifications, the monetary policy shock is not invertible, but is recoverable. When using our procedure, results are plausible even in a parsimonious specification, not including financial variables. Monetary policy has significant and sizeable effects on prices.

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