Representing uncertainty about response paths: The use of heuristic optimisation methods
Introduction
It is routine to carry out impulse response analysis when a vector autoregressive model (VAR) is fitted. There is a considerable literature on how best to construct confidence intervals for the responses, that is for the response at a particular time. By contrast, the construction of confidence bands for the entire response path has received very little attention although it is a subject of considerable interest. Confidence intervals for responses are often plotted against time with the highest points in successive intervals and the lowest points joined so that the reader is almost invited to interpret the area between the two lines as a confidence band for the entire path. This is a rather hazardous proceeding for a coverage of 95%, say, for each of the intervals will not necessarily produce anything like a 95% coverage for the band. The present paper takes off from the belief that there should be some gain in taking a more considered approach than joining the intervals and hoping for the best. The methods proposed combine bootstrapping, which is now widely used for the construction of intervals, with the use of heuristic optimisation methods for finding the narrowest band for the entire path. The approach, which is a natural extension of bootstrapped confidence intervals, appears not to have been tried before although Sims and Zha (1999) have treated band construction from a likelihood/Bayesian viewpoint.
The paper begins with an account of the relationship between confidence intervals and confidence bands, continues with an exposition of different ways of performing the basic bootstrap exercise and then describes alternative methods of constructing bands based on the bootstrap. These alternative methods employ different optimisation techniques. The procedures for producing confidence bands are then evaluated for a simple stationary data generating process (DGP) and for a vector error correction model (VECM) of the kind used in empirical work. It is found that the coverage probabilities obtained for the ad hoc procedures of joining up the confidence intervals are substantially less than the desired value while the proposed methods for constructing confidence bands perform well for short horizons, at least, and always achieve much higher coverage probabilities than the joined up intervals.
Section snippets
Confidence intervals and confidence bands
We begin by noting the inconclusiveness of reasoning from the properties of intervals for particular responses to the properties of bands for the entire response path. The main point is that knowing the confidence levels for the intervals for each period may tell us little about the confidence level of the band produced by joining up the intervals.
The standard result linking joint probabilities to marginal probabilities is Bonferroni's inequality; see Miller (1980). This states that for any
The bootstrap procedure
The objective of impulse response analysis is to discover how the VAR responds to typical economic shocks. This objective has been interpreted in different ways, corresponding to different views of what is economically reasonable and intelligible; see Aldrich and Staszewska (2007) for discussion. Three distinct forms of economic experiment have been proposed leading to traditional, generalised and orthogonalised impulse response analysis; the terms are from Koop et al. (1996). The confidence
Constructing confidence bands
The basic method for constructing a 95% confidence interval for the response for a given period is to order the B bootstrap values for that period and identify the top and bottom 2.5 percentiles. In the case of paths there is no underlying ordering because the paths typically cross. The guiding idea of discarding extreme paths can be retained but the implementation has to be changed; in fact, the idea can be implemented in several different ways.
Formal optimisation methods can be used. There
Preliminaries: a stationary DGP
The main evaluation of the methods is presented in Sections 6 and 7 but it is interesting to consider their performance when applied to a simpler case, a bivariate stationary process of the kind considered by Kilian (1998). Kilian found that his method of interval construction was superior to the standard method. We find that the band methods based on his bias correction procedure also perform quite well.
Following Kilian, the data generating process for the Monte Carlo experiments is:
A nonstationary DGP with cointegration
Our main Monte Carlo investigation is based on a model which is widely used in macroeconometrics, the conditional VEC model: where is the vector of endogenous variables, is the vector of weakly exogenous or conditioning variables and is a vector of deterministic terms. The matrix contains the adjustment coefficients and the matrix contains the long-run parameters.
The version of this model we use as the data generating process for
Results and evaluation
This section reports the results of the main Monte Carlo experiments investigating coverage probabilities and also the results from some subsidiary studies. Table 5 shows the performance of the various methods for constructing confidence bands for 24 periods ahead; the economic experiment is the same as that behind Figs. 1–3, viz. the traditional impulse response analysis considering the effects on the three endogenous variables of a one standard deviation shock to .
While the probabilities are
Conclusions
Our main finding is that it is possible to produce confidence bands which are much more successful in achieving a desired confidence level than the technique of joining up confidence intervals. This conclusion is likely to hold in other circumstances although the detailed findings are subject to the important caveat that they relate to a restricted set of experiments using a particular DGP. Of the methods considered the ones using the Kilian bias correction performed best. The performance
Acknowledgements
Support from the EU Commission through MRTN-CT-2006-034270 is gratefully acknowledged. The author would like to thank the editors and the referees for their comments and suggestions.
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