Vector Autoregressions with Parsimoniously Time Varying Parameters and an Application to Monetary Policy

Abstract

This paper proposes a parsimoniously time varying parameter vector autoregressive model (with exogenous variables, VARX) and studies the properties of the Lasso and adaptive Lasso as estimators of this model. The parameters of the model are assumed to follow parsimonious random walks, where parsimony stems from the assumption that increments to the parameters have a non-zero probability of being exactly equal to zero. By varying the degree of parsimony our model can accommodate constant parameters, an unknown number of structural breaks, or parameters with a high degree of variation. We characterize the finite sample properties of the Lasso by deriving upper bounds on the estimation and prediction errors that are valid with high probability; and asymptotically we show that these bounds tend to zero with probability tending to one if the number of non zero increments grows slower than $\sqrt{T}$. By simulation experiments we investigate the properties of the Lasso and the adaptive Lasso in settings where the parameters are stable, experience structural breaks, or follow a parsimonious random walk. We use our model to investigate the monetary policy response to inflation and business cycle fluctuations in the US by estimating a parsimoniously time varying parameter Taylor rule. We document substantial changes in the policy response of the Fed in the 1980s and since 2008.