Monetary Policy and the Exchange Rate: Evaluation of VAR Models

This paper examines the ability of vector autoregressive (VAR) models to properly identify the transmission of monetary policy in a controlled experiment. Simulating data from an estimated small open economy DSGE model for Australia, we find that sign-restricted VAR models do reasonably well at estimating the responses of macroeconomic variables to monetary policy shocks. This is in contrast to models that use recursive zero-type restrictions, for which inflation can rise following an unexpected interest rate increase while the exchange rate can appreciate or depreciate depending on the ordering of the variables. However, central tendency measures of sign-restricted VAR models can be misleading and hardly ever coincide with the true impulses. This finding casts doubt on the common notion that the median impulses are the ‘most probable’ description of the true data generating process. Finally, the paper presents some results from a sign-restricted VAR model estimated using Australian data.