Controls, not shocks: estimating dynamic causal effects in macroeconomics

Simon Lloyd and Ed Manuel

No 1079, Bank of England working papers from Bank of England

Abstract: A common approach to estimating causal effects in macroeconomics involves constructing orthogonalised ‘shocks’ then integrating them into local projections or vector autoregressions. For a general set of estimators, we show that this two-step ‘shock-first’ approach can be problematic for identification and inference relative to a one-step procedure which simply adds appropriate controls directly in the outcome regression. We show this analytically by comparing one and two-step estimators without assumptions on underlying data-generating processes. In simple ordinary least squares (OLS) settings, the two approaches yield identical coefficients, but two-step inference is unnecessarily conservative. More generally, one and two-step estimates can differ due to omitted-variable bias in the latter when additional controls are included in the second stage or when employing non-OLS estimators. In monetary-policy applications controlling for central-bank information, one-step estimates indicate that the (dis)inflationary consequences of US monetary policy are more robust than previously realised, not subject to a ‘price puzzle’.

Keywords: Identification; instrumental variables; local projections; omitted-variable bias; vector autoregressions (search for similar items in EconPapers)
JEL-codes: C22 C26 C32 C36 E50 E60 (search for similar items in EconPapers)
Pages: 48 pages
Date: 2024-08-06
New Economics Papers: this item is included in nep-cba, nep-ecm and nep-ets
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Working Paper: Controls, Not Shocks: Estimating Dynamic Causal Effects in Macroeconomics (2024)
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Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:1079

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