Factor augmented VAR revisited: A sparse dynamic factor model approach

We combine the factor augmented VAR framework with recently developed estimation and identification procedures for sparse dynamic factor models. Working with a sparse hierarchical prior distribution allows us to discriminate between zero and non-zero factor loadings. The non-zero loadings identify the unobserved factors and provide a meaningful economic interpretation for them. Given that we work with a general covariance matrix of factor innovations, we can implement different strategies for structural shock identification. Applying our methodology to US macroeconomic data (FRED QD) reveals indeed a high degree of sparsity in the data. The proposed identification procedure yields seven unobserved factors that account for about 52 percent of the variation in the data. We simultaneously identify a monetary policy, a productivity and a news shock by recursive ordering and by applying the method of maximizing the forecast error variance share in a specific variable. Factors and specific variables show sensible responses to the identified shocks.