FACTOR-AUGMENTED VECTOR AUTOREGRESSIVE (FAVAR) ANALYSIS OF MONETARY POLICY IN NIGERIA

Adebayo Adebiyi () and Charles N. O. Mordi

No 3762, EcoMod2012 from EcoMod

Abstract: The objective of this paper is to build and use FAVAR model to evaluate the responses of a wide range of macroeconomic variables to monetary policy shocks. FAVAR is superior to standard VAR for many reasons. One, with Factor VAR model, it is possible to combine the standard VAR approach with factor analysis and provide a proper identification of the monetary transmission mechanism (Stock and Watson, 1998; Bernanke et al., 2005; Boivin and Giannoni, 2006). Two, the methodology makes it possible to assess how much of the observed movements of a large number of macroeconomic variables (particularly real variables) can be attributed to monetary policy rate. Three, FAVARs allow a better identification of the monetary policy shock, since they condition on a more realistic information set. Also, while in low-dimensional VARs, impulse responses can be derived only for the few included variables, with FAVARs, it is possible to construct the impulse responses for all the numerous economic series used in the construction of the factors (Bernanke, Boivin, and Eliasz, 2005). The paper employs a Factor-Augmented VAR model by incorporating a real activity factor, covering the theoretical and unobservable macroeconomic concept of `output gap', an inflation factor, a long-term interest rates factor, a financial market factor, and money and credit is included. The paper, then use Bayesian approach to jointly estimate the factors and the dynamic model. This framework is then used to study the effects of monetary policy on a wide range of macroeconomic variables. This range of variables included is considered more suitable than a single observable variable to capture the real economic activity. It is observed that the information obtained from FAVAR methodology is vital to properly identify the monetary policy transmission mechanism in Nigeria. The results provide a comprehensive and coherent picture of the effect of monetary policy on the Nigerian economy.

Keywords: Nigeria; Modeling: new developments; Monetary issues (search for similar items in EconPapers)
Date: 2012-07-01
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Persistent link: https://EconPapers.repec.org/RePEc:ekd:002672:3762

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