A global-local prior for time-varying parameter VARs and monetary policy

Abstract

Time-varying parameter VARs have become the workhorse models in empirical macroeconomics. These models are usually equipped with tightly parametrized prior distributions which favor a small and gradual change in parameters. Do such prior distributions suppress some degree of time variation in the VAR coefficients? We address this question by proposing a exible global-local prior. It turns out that the conventional prior may suppress economically relevant patterns of time variation. Using the global-local prior, we observe that parameter change can be abrupt rather than smooth. We find that, during the chairmanship of Paul Volcker, the Fed has been fighting inflation pressures by raising the interest rate in response to a negative supply shock. However, during the chairmanship of Alan Greenspan, this policy came to an end. In contrast, using the conventional prior, we do not detect this pattern.