Universit`

a di Pavia

Impulse Response Functions

Eduardo Rossi

VAR
VAR(p):
yt = (y1t , . . . , yN t )
(L)yt = t
(L) = IN 1 L . . . p Lp
t = (1t , . . . , N t )
t independent V W N (0, )
The process is stable if
det(IN 1 z . . . p z p ) 6= 0 for |z| 1
On the assumption that the process has been initiated in the infinite
past (t = 0, 1, 2, . . .) it generates stationary time series that have
time-invariant means, variances, and covariances.
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Econometrics 10

VAR

Because VAR models represent the correlations among a set of

variables, they are often used to analyze certain aspects of the
relationships between the variables of interest.

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Granger-Causality
Granger (1969) has defined a concept of causality which,under
suitable conditions, is fairly easy to deal with in the context of VAR
models. Therefore it has become quite popular in recent years. The
idea is that a cause cannot come after the effect.
If a variable x affects a variable z, the former should help improving
the predictions of the latter variable.
t is the information set containing all the relevant information in
the universe available up to and including period t.
zt (h|t ) be the optimal (minimum MSE) h-step predictor of the
process zt at origin t, based on the information in t .
The corresponding forecast MSE: t (h|t ).

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Econometrics 10

Granger-Causality

The process xt is said to cause zt in Grangers sense if

t (h|t ) < t (h|t {xs : s t})

for at least one

h = 1, 2, . . .

t {xs : s t} is the set containing all the relevant information in

the universe except for the information in the past and present of the
xt process.
If zt can be predicted more efficiently if the information in the xt
process is taken into account in addition to all other information in
the universe, then xt is Granger-causal for zt .

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Econometrics 10

Instantaneous Causality

If xt : (N 1) causes zt : (M 1) and zt also causes xt

the process (zt , xt ) is called a feedback system.
We say that there is instantaneous causality between zt and xt if
z (1|t xt+1 ) 6= z (1|t )
In other words, in period t, adding xt+1 to the information set helps
to improve the forecast of zt+1 .
This concept of causality is really symmetric, that is, if there is
instantaneous causality between zt and xt , then there is also
instantaneous causality between xt and zt .

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Econometrics 10

Instantaneous Causality

A possible criticism of the foregoing definitions could relate to the

choice of the MSE as a measure of the forecast precision. Of course,
the choice of another measure could lead to a different definition of
causality.
Equality of the MSEs will imply equality of the corresponding
predictors.
In that case a process zt is not Granger-caused by xt if the optimal
predictor of zt does not use information from the xt process. This
result is intuitively appealing.

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Econometrics 10

Instantaneous Causality

A more serious practical problem is the choice of the information set

t . Usually all the relevant information in the universe is not
available to a forecaster and, thus, the optimal predictor given t
cannot be determined. Therefore a less demanding definition of
causality is often used in practice.

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Instantaneous Causality

Instead of all the information in the universe, only the information in

the past and present of the process under study is considered relevant
and t is replaced by {zs , xs |s t}. Furthermore, instead of optimal
predictors, optimal linear predictors are compared.

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Impulse responses functions

Granger-causality may not tell us the complete story about the
interactions between the variables of a system.
In applied work, it is often of interest to know the response
of one variable to an impulse in another variable in a system
that involves a number of further variables as well.
One would like to investigate the impulse response relationship
between two variables in a higher dimensional system. Of course, if
there is a reaction of one variable to an impulse in another variable
we may call the latter causal for the former.
We will study this type of causality by tracing out the effect of an
exogenous shock or innovation in one of the variables on some or all
of the other variables.
This kind of impulse response analysis is called multiplier analysis.
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Impulse responses functions

For instance, in a system consisting of an inflation rate and an

interest rate, the effect of an increase in the inflation rate may be of
interest.
In the real world, such an increase may be induced exogenously from
outside the system by events like the increase of the oil price in
1973/74 when the OPEC agreed on a joint action to raise prices.
Alternatively, an increase or reduction in the interest rate may be
administered by the central bank for reasons outside the simple two
variable system under study.

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Impulse responses functions

Three-variables system:

investment
y1,t

yt = y2,t
income

y3,t
consumption
the effect of an innovation in investment. To isolate such an effect,
suppose that all three variables assume their mean value prior to
time t = 0, yt = , t < 0, and investment increases by one unit in
period t = 0, i.e. 10 = 1.

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Impulse responses functions

Now we can trace out what happens to the system during periods
t = 1, 2, . . . if no further shocks occur, that is,
20 = 30 = 0
and
2 = 0, 3 = 0, . . .
We assume that all three variables have mean zero and set c = 0,
then
yt = 1 yt1 + t

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Impulse responses functions

y1,t

.5

y1,t1

1,t

yt = y2,t = .1 .1 .3 y2,t1 + 2,t

y3,t
0 .2 .3
y3,t1
3,t
Tracing a unit shock in the first variable in period t = 0 in this
system we get

y1,0
1,0
1

y0 =
y2,0 = 2,0 = 0
y3,0
3,0
0

y1,1

0.5

y1 = y2,1 = 1 y0 = 0.1

y3,1
0
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Impulse responses functions

y1,2

0.5

y2 = y2,2 = 1 y1 = 1 y0 = 0.06

y3,2
0.02
it turns out that yi = (y1,i , y2,i , y3,i ) is just the first column of i1
yi = i1 ui
where
ui = (0, 0, . . . , 1, . . . , 0)
the elements of i1 represent the effects of unit shocks in the
variables of the system after i periods. They are called impulse
responses or dynamic multipliers.

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Impulse responses functions

Recall that i1 = i just the i-th coefficient matrix of the MA

representation of a VAR(1) process.
The MA coefficient matrices contain the impulse responses of the
system. This result holds more generally for higher order VAR(p)
processes as well.
V M A () representation:
yt =

i ti

0 = In

i=0

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Impulse responses functions

Impulse-response function
yt+n =

i t+ni

i=0

{n }i,j =

yit+n
jt

the response of yi,t+n to a one-time impulse in yj,t with all other

variables dated t or earlier held constant.
The response of variable i to a unit shock (forecast error) in variable
j is sometimes depicted graphically to get a visual impression of the
dynamic interrelationships within the system.

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Impulse responses functions

If the variables have different scales, it is sometimes useful to consider
innovations of one standard deviation rather than unit shocks.
For instance, instead of tracing an unexpected unit increase in
investment in the investment/income/consumption system with

V ar(1,t ) = 2.25, one may follow up on a shock of 2.25 = 1.5 units

because the standard deviation of 1,t is 1.5.
Of course, this is just a matter of rescaling the impulse responses.
The impulse responses are zero if one of the variables does not
Granger-cause the other variables taken as a group.
An innovation in variable k has no effect on the other variables if the
former variable does not Granger-cause the set of the remaining
variables.
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The Orthogonalized Impulse-Response Function

A problematic assumption in this type of impulse response analysis is
that a shock occurs only in one variable at a time. Such an
assumption may be reasonable if the shocks in different variables are
independent.
If they are not independent one may argue that the error terms
consist of all the influences and variables that are not directly
included in the set of y variables.
Thus, in addition to forces that affect all the variables, there may be
forces that affect variable 1, say, only. If a shock in the first variable
is due to such forces it may again be reasonable to interpret the i
coefficients as dynamic responses.

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The Orthogonalized Impulse-Response Function

On the other hand, correlation of the error terms may indicate that a
shock in one variable is likely to be accompanied by a shock in
another variable.
In that case, setting all other errors to zero may provide a misleading
picture of the actual dynamic relationships between the variables.

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The Orthogonalized Impulse-Response Function

This is the reason why impulse response analysis is often performed
in terms of the MA representation:
= PP

Cholesky decomposition

P is a lower triangular matrix. From

yt = t + 1 t1 + 2 t2 + . . .

0 = In

to
yt = 0 wt + 1 wt1 + 2 wt2 + . . .
with
i = i P
wt = P1 t
E[wt wt ] = IN
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The Orthogonalized Impulse-Response Function

It is reasonable to assume that a change in one component of wt has
no effect on the other components because the components are
orthogonal (uncorrelated).
Moreover, the variances of the components are one. Thus, a unit
innovation is just an innovation of size one standard deviation.
The elements of the i are interpreted as responses of the system to
such innovations.
{i }jk
is assumed to represent the effect on variable j of a unit innovation in
the k-th variable that has occurred i periods ago.

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The Orthogonalized Impulse-Response Function

To relate these impulse responses to a VAR model, we consider the

zero mean VAR(p)process:
(L)yt = t
This process can be rewritten in such a way that the disturbances of
different equations are uncorrelated. For this purpose, we choose a
decomposition of the white noise covariance matrix
= WW
is a diagonal matrix with positive diagonal elements and W is a
lower triangular matrix with unit diagonal.

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The Orthogonalized Impulse-Response Function

This decomposition is obtained from the Choleski decomposition

= PP by defining a diagonal matrix D which has the same main
diagonal as P and by specifying
W = PD1
= DD
then from
= PP
and
P = WD
= PP = WDD W = WW

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The Orthogonalized Impulse-Response Function

Premultiplying the VAR(p) by A W1

Ayt = A1 yt1 + . . . + Ap ytp + et
where
Ai = Ai
et = At

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The Orthogonalized Impulse-Response Function

et has a diagonal var-cov matrix:

E[et et ] = AE[t t ]A = AA
Adding (IN A)yt to both sides gives
(IN A)yt + Ayt = (IN A)yt + A1 yt1 + . . . + Ap ytp + et
yt = A0 yt + A1 yt1 + . . . + Ap ytp + et
Because W is lower triangular with unit diagonal, the same is true
for A.

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The Orthogonalized Impulse-Response Function

Hence,
A0 = (IN A)

0
0

0
12
.
..

.
= ..

..
.

N,1 N,2

...
...

0
0
..

. . . N,N 1

0
0
..
.
..
.
0

is a lower triangular matrix with zero diagonal and, thus, in the

representation of the VAR(p) process, the first equation contains no
instantaneous ys on the right-hand side. The second equation may
contain y1,t and otherwise lagged ys on the right-hand side. More
generally,the k-th equation may contain y1,t , . . . , yk1,t and not
yk,t , . . . , yN,t on the right-hand side.
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The Orthogonalized Impulse-Response Function

Thus, if the VAR(p) with instantaneous effects reflects the actual

ongoings in the system, yst cannot have an instantaneous impact on
ykt for k < s.
In the econometrics literature such a system is called a recursive
model (Theil (1971)). Wold has advocated these models where the
researcher has to specify the instantaneous causal ordering of the
variables. This type of causality is therefore sometimes referred to as
Wold-causality.

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The Orthogonalized Impulse-Response Function

If we trace eit innovations of size one standard error through the

system, we just get the impulse responses. This can be seen by
solving the system for yt :
(IN A0 )yt = A1 yt1 + . . . + Ap ytp + et
yt = (IN A0 )1 A1 yt1 +. . .+(IN A0 )1 Ap ytp +(IN A0 )1 et
Noting that (IN A0 )1 = W = PD1 shows that the instantaneous
effects of one-standard deviation shocks (eit s of size one standard
deviation) to the system are represented by the elements of
WD = P = 0
because the diagonal elements of D are just standard deviations of
the components of et .

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The Orthogonalized Impulse-Response Function

The i may provide response functions that are quite different from
the i responses.
Note that 0 = P is lower triangular and some elements below the
diagonal will be nonzero if has nonzero off-diagonal elements.
For the investment/income/consumption example

1.5 0
0

0 = P = 0
1
0

0 0.5 0.7
indicates that an income (y2 ) innovation has an immediate impact on
consumption (y3 ).

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Econometrics 10

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The Orthogonalized Impulse-Response Function

If the white noise covariance matrix contains zeros, some
components of t are contemporaneously uncorrelated. Suppose,for
instance, that 1t is uncorrelated with it , i = 2, . . . , N .
In this case, A = W1 and thus A0 has a block of zeros so that y1
has no instantaneous effect on yi , i = 2, . . . , N . In the
example,investment has no instantaneous impact on income and
consumption because

2.25 0
0

= 0
1
0.5

0
0.5 0.74
1t is uncorrelated with 2t and 3t . This, of course, is reflected in the
matrix of instantaneous effects 0 (impact multipliers).

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The Orthogonalized Impulse-Response Function

The fact that 0 is lower triangular shows that the ordering of the
variables is of importance, that is, it is important which of the
variables is called y1 and which one is called y2 and so on.
One problem with this type of impulse response analysis is that the
ordering of the variables cannot be determined with statistical
methods but has to be specified by the analyst. The ordering has to
be such that the first variable is the only one with a potential
immediate impact on all other variables.
The second variable may have an immediate impact on the last
N 2 components of yt but not on y1t and so on. To establish such
an ordering may be a quite difficult exercise in practice.

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The Orthogonalized Impulse-Response Function

The choice of the ordering, the Wold causal ordering, may, to a large
extent, determine the impulse responses and is therefore critical for
the interpretation of the system.
For the investment/income/consumption example it may be
reasonable to assume that an increase in income has an immediate
effect on consumption while increased consumption stimulates the
economy and, hence, income with some time lag.

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The Orthogonalized Impulse-Response Function

Besides specifying the relevant impulses to a system, there are a

number of further problems that render the interpretation of impulse
responses difficult.
A major limitation of our systems is their potential
incompleteness.Although in real economic systems almost everything
depends on everything else, we will usually work with
low-dimensional VAR systems.
All effects of omitted variables are assumed to be in the innovations.
If important variables are omitted from the system,this may lead to
major distortions in the impulse responses and makes them worthless
for structural interpretations.

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The Orthogonalized Impulse-Response Function

Consider a system yt which is partitioned in vectors zt and xt , with
VMA representation

zt
1
11 (L) 12 (L)
1t

yt =
=
+
xt
2
21 (L) 22 (L)
2t
If the zt variables are considered only and the xt variables are
omitted from the analysis, we get a prediction error MA
representation:
zt = 1 +

11,i 1ti +

Fi vti

i=0

zt = 1 +

12,i 2ti

i=1

i=0

The actual reactions of the zt components to innovations 1t may be

given by the 11,i matrices.
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The Orthogonalized Impulse-Response Function

On the other hand,the Fi or corresponding orthogonalized impulse

response are likely to be interpreted as impulse responses if the
analyst does not realize that important variables have been omitted.
The Fi will be equal to the 11,i , if and only if xt does not
Granger-cause zt .

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MA Representation
The stable VAR(p) has a Wold MA representation:
yt = t + 1 t1 + 2 t2 + . . .
where
s = sj=1 sj j

s = 1, 2, . . .

with 0 = IK . The elements of the j are the forecast error impulse

responses.
Different ways to orthogonalize the impulses. Cholesky
decomposition of . Such an approach is arbitrary, unless there are
special reasons for a recursive structure.
Different ways to use nonsample information in specifying unique
innovations and hence unique i-r.

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SVAR

Structural form model

Ayt = 1 yt1 + 2 yt2 + . . . + p ytp + Bet
The matrix A contains the instantaneous relations between the
left-hand-side variables. It has to be invertible.

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SVAR

The reduced forms are obtained by premultiplying with A1

yt = A1 1 yt1 + A1 2 yt2 + . . . + A1 p ytp + A1 Bet
t = A1 Bet
which relates the reduced-form disturbances t to the underlying
structural shocks et .

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SVAR
To identify the structural form parameters, we must place
restrictions on the parameter matrices.
Even if A = IN the assumption of orthogonal shocks
E [et et ] = IN
is not sufficient to achieve identification.
For a N -dimensional system,

N (N 1)
2

restrictions are necessary for

orthogonalizing the shocks because there are N (N21) potentially

different instantaneous covariances.
An example of such an identification scheme is the triangular (or
recursive) identification suggested by Sims (1980). Such a scheme is
also called Wold causal chain system and is often associated with a
causal chain from the first to the last variable in the system.

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Identification

Because the i-r functions computed from these models depend on the
ordering of the variables, nonrecursive identification schemes that
also allow for instantaneous effects of the variables
A 6= IN
have been suggested in the literature (Sims (1986), Bernanke (1986)).
Restrictions on the long-run effects of some shocks are also used to
identify SVAR models (Blanchard and Quah (1989), Gal` (1999),
King, Plosser, Stock, and Watson (1991)).

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Identification

At = Bet
The most popular kind of restrictions:
B = IN , the A-model.
A = IN , the innovation is t = Bet , the B-model.
the AB-model
Prior information.

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