Identifying Monetary Impacts on Agricultural Prices in VAR Models

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Since the mid-1970s, a number of studies have used vector autoregressive (VAR) models to evaluate the magnitude and timing of macroeconomic impacts on agriculture. Use of the VAR method has been viewed as a way to obtain empirical evidence about these impacts that might not emerge from more traditional overidentified and less dynamic econometric models. The hope has been that by placing minimal restrictions on VAR models, the true structure of the economic relationships under investigation can be observed. While the aim is laudable, critics of VAR models have argued that it has had the unfortunate consequence of obscuring some important structural identification issues and seeming to promise that something can be obtained for nothing (Cooley and Leroy, Leamer). They point out that identifying restrictions are required to give economically interpretable meaning to the results of any simultaneous equation model (SEM). In standard practice, identification of VAR models is obtained implicitly by choice of a Choleski decomposition of the covariance matrix of one-step-ahead forecast errors, which is equivalent to imposing a recursive structure for the economy. Of concern is that the recursive structure may not be believable. Further, as Bernanke has observed, examination of ad hoc variants of the recursive order implies a strange set of prior beliefs in which the analyst holds strongly that the system is recursive but is not sure in what order the variables should be arranged. In response to these concerns, several recent papers have pointed out that identification of VAR models does not have to rely on the assumption that the contemporaneous structure is recursive (Bernanke, Sims). Rather, the distinguishing features of a VAR model are, first, that identification rests on the assumption that distinct, mutually orthogonal behavior shocks drive the economy, and, second, that lagged relationships among the endogenous and exogenous variables (if any) are left entirely unrestricted. Given these features, a VAR model must be identified solely by restrictions placed on the contemporaneous interactions among the variables, but the identifying restrictions do not have to preclude simultaneity. In this paper, we elaborate on the structural interpretation of VAR models and use this analysis to examine monetary impacts on agricultural prices. We discuss the identification problem and the implications of a recursive structure. We illustrate our points with respect to the three-variable model of money, industrial prices, and agricultural prices that has been used in several articles to evaluate the effects of monetary shocks on price dynamics (Bessler, Devadoss and Meyers). We then introduce a somewhat richer behavioral model of the macroeconomy and its effects. A simultaneous model is shown to offer a more believable identification of monetary policy and other macroeconomic shocks than a recursive model, and monetary impacts on agricultural prices are assessed.