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The Econometrics of Monetary Policy:

An Overview

Carlo A. Favero

Abstract
This chapter concentrates on the econometrics of monetary policy. We describe the evolution
of models estimated to evaluate the macroeconomic impact of monetary policy. We argue that
the main challenge for the econometrics of monetary policy is in combining theoretical models
and information from the data to construct empirical models. The failure of the large econo-
metric models at the beginning of the 1970s might be explained by their incapability of taking
proper account of both these aspects. The critiques by Lucas and Sims have generated an alter-
native approach which, at least initially, has been almost entirely dominated by theory. The LSE
approach has instead concentrated on the properties of the statistical models and on the best way
of incorporating information from the data into the empirical models, paying little attention to
the economic foundation of the adopted specification. The realization that the solution of a DSGE
model can be approximated by a restricted VAR, which is also a statistical model, has generated
a potential link between the two approaches. The open question is which type of VARs are most
appropriate for the econometric analysis of monetary policy.

16.1 The econometrics of monetary policy: what have we learnt? 821
16.2 The econometrics of monetary policy in large econometric models 825
16.3 The different diagnoses of the failure of large econometric models 827
16.3.1 Diagnoses related to structural identification 827
16.3.2 Diagnoses related to statistical identification 828
16.4 Model specification and model diagnostics when statistical identification matters 829
16.5 Model specification and model diagnostics when structural identification matters 830
16.5.1 VAR-based model evaluation: an assessment 835
16.6 From VAR-based model evaluation to Bayesian analysis of DSGE models 838
16.6.1 DSGE-VAR analysis: an assessment 841
16.7 What’s next? 843
16.8 Appendix: The Sims (2000) representation of a small macroeconomic model 844

16.1 The econometrics of monetary policy: what have we learnt?

Econometric evaluation of monetary policy started with large simultaneous
equation models, in the tradition of the Cowles Commission. This first generation
of models was largely driven by the IS/LM framework, in which the supply side was

821