Structural VARs, deterministic and stochastic trends: Does detrending matter?

Release date
14/05/2015
Reference
DP2015/02
Authors
Varang Wiriyawit; Benjamin Wong
Published as

Wiriyawit, Varang and Benjamin Wong (2016). ‘Structural VARs, deterministic and stochastic trends: how much detrending matters for shock identification’, Studies in Nonlinear Dynamics and Econometrics, De Gruyter, Volume 20(2), Pages 141-157, DOI: https://doi.org/10.1515/snde-2015-0030.

We highlight how detrending within Structural Vector Autoregressions (SVAR) is directly linked to the shock identification. Consequences of trend misspecification are investigated using a prototypical Real Business Cycle model as the Data Generating Process. Decomposing the different sources of biases in the estimated impulse response functions, we find the biases arising directly from trend misspecification are not trivial when compared to other widely studied misspecifications. Misspecifying the trend can also distort impulse response functions of even the correctly detrended variable within the SVAR system. A possible solution hinted by our analysis is that increasing the lag order when estimating the SVAR may mitigate some of the biases associated with trend misspecification.