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Identification To illustrate the identification procedure, return to the twovariable/first-order VAR of the previous section. Due to the feedback inherent in a VAR process, the primitive equations (5.17) and (5.18) cannot be estimated directly. The reason is that zt is correlated with the error term εyt and that yt is correlated with the error term εzt. Standard estimation techniques require that the regressors be uncorrelated with the error term. Note that there is no such problem in estimating the VAR system in the form of (5.20) and (5.21). OLS can provide estimates of the two elements of A0 and of the four elements of A1. Moreover, obtaining the residuals from the two regressions, it is possible to calculate estimates of the variance of e1t, e2t, and of the covariance between e1t, with e2t. The issue is whether it is possible to recover all of the information present in the primitive system given by (5.17) and (5.18). In other words, is the primitive system identifiable given the OLS estimates of the VAR model in the form of (5.20) and (5.21)? The answer to this question is, “No, unless we are willing to appropriately restrict the primitive system.” The reason is clear if we compare the number of parameters of the primitive system with the number of parameters recovered from the estimated VAR model. Estimating (5.20) and (5.21) yields six coefficient estimates(a10, a20, a11, a12, a21, and a22) and the calculated values of var(e1t), var(e2t), and cov(e1t, e2t). However, the primitive system (5.17) and (5.18) contains ten parameters. In addition to the two intercept coefficients b10 and b20, the four autoregressive coefficients Υ11, Y12, Y21, and Y22, and the two feedback coefficients b12 and b21, there are the two standard deviations y and z . In all, the primitive system contains ten parameters whereas tha VAR estimation yields only

Imposing the restriction b21 = 0 means that B-1 is given by . . Writing (5..23) as ..17) and (5... it follows that e1t = εyt – b12εzt and e21 = εzt Hence. Now..31) (5......22) and (5..17) and (5. we can rewrite the relationship between the pure shocks and the regression residuals given by (5....... One way to identify the model is to use the type of recursive system proposed by Sims (1980). Nevertheless. Unless one is willing to restrict one of the parameters.... The point is that forcing b21 = 0 means that zt has a contemporaneous effect on yt but yt affects the {zt} sequencewith a one-period lag. Since b21=0.... it is not possible to identify the primitive system... Estimating the system using OLS yields the parameter estimates from .... or ...18) are underidentified.... .nine parameters..... premultiplication of the primitive system by B-1 yields ..... it should be clear that this restriction (which might be suggested by a particular economic model) result in an exactly identified system.. Suppose that you are willing to impose a restriction on the primitive system such that the coefficient b21 equal to zero..32) Similarly. where . equations (5.18) with the constraint imposed yields (5.....

γ12. var(e1). Take a minute to examine the restriction. a21. a20.33). it forces exactly (n2 – n)/2 values of the B matrix to equal zero. the result is quite general.Thus. 2y. we have nine parameter estimates a10. e2) that can be substituted into the nine equations above in order to simultaneously solve for b10. γ11. a11. Combining these estimates along with the solution for b12 allows us to calculate the estimates of the {εyt} sequence using the relationship e1t = εyt – b12εzt.e. B is an n. In (5. Decomposing the residuals in this triangular fashion is called a Choleski decomposition. var(e2). exact identification requires that (n2 – n)/2 restrictions be placed on the relationship between the regression residuals and the structural innovations. Since the Choleski decomposition is triangular. n matrix since there are n regression residuals and n structural shocks. The observed values of e2t are completely attributed to pure shocks to the {zt} sequence.. The residuals from the second equation (i. and 2z. the assumption b21 = 0 means that yt does not have a contemporaneous effect of zt. a22. . the {e2t} sequence) are estimates of the {εzt} sequence. In an n-variable VAR. b12. In (5. Note also that the estimates of the {εyt} and {εzt} sequences can be recovered. the restriction manifests itself such that both εyt and εzt shocks affect the contemporaneous value of yt but only εzt shocks affect the contemporaneous value of zt. As shown in Section 10.32). a12. In fact. and cov(e1. b20.