Identification and Estimation of Dynamic Causal Effects in Macroeconomics Using External Instruments

James H. Stock and Mark Watson

Economic Journal, 2018, vol. 128, issue 610, 917-948

Abstract: External sources of as†if randomness — that is, external instruments — can be used to identify the dynamic causal effects of macroeconomic shocks. One method is a one†step instrumental variables regression (local projections – IV); a more efficient two†step method involves a vector autoregression. We show that, under a restrictive instrument validity condition, the one†step method is valid even if the vector autoregression is not invertible, so comparing the two estimates provides a test of invertibility. If, however, lagged endogenous variables are needed as control variables in the one†step method, then the conditions for validity of the two methods are the same.

Date: 2018
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Working Paper: Identification and Estimation of Dynamic Causal Effects in Macroeconomics Using External Instruments (2018)
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