Solved – VAR Impulse response with dummies

categorical dataeconometricsimpulse responsevector-autoregression

I have dummy variables (DV) which measure policy reforms (e.g. Independence of the judiciary, barriers-to-entry in a market etc.). These can be either “0,1” or, say, “0,1,2,….. upper”.

Say I have a VAR or VECM with these dummies in them. Two problems follow:

  1. Is it legitimate to do impulse responses on dummies? They are after all categorical variables, bound on a given interval. Does a temporary shock to a DV even make sense (=> a policy maker implements a reform, then withdraws it??). And if only permanent reforms make sense, how do you model agents’ learning of the reform since presumably you need to shock the dummy down in each period.

  2. The policy reforms on which the dummies are predicated aren’t exogenous events. They can reflect past poor economic performance, electoral changes etc. And yet the dummies (taken from external databases) are notionally considered exogenous.

Best Answer

If the policy dummies were exogenous you could use a VAR-X model and do dynamic multiplier analysis (see Lutkepohl 2005 Chp. 10). But since you are sure that the dummy variable is endogenous you might take a look at the Qual-VAR model due to Dueker JBES 2005, which essentially includes a dynamic probit equation in a standard VAR model. His application is to forecasting, but I don't see a reason why you could not do IRFs as well, as in a standard VAR. You'll have no choice but to do a Bayesian estimation via MCMC as Dueker does. Dueker and others have follow up papers on the Qual-VAR model.

Hope this helps!