An identification and testing strategy for Proxy-SVARs with weak proxies

Abstract

When proxies (external instruments) used to identify target structural shocks are weak, inference in proxy-SVARs (SVAR-IVs) is nonstandard and the construction of asymptotically valid confidence sets for the impulse responses of interest requires weak-instrument robust methods. In the presence of multiple target shocks, test inversion techniques require extra restrictions on the proxy-SVAR parameters other those implied by the proxies that may be difficult to interpret and test. We show that frequentist asymptotic inference in these situations can be conducted through Minimum Distance estimation and standard asymptotic methods if the proxy-SVAR can be identified by using `strong' instruments for the non-target shocks; i.e. the shocks which are not of primary interest in the analysis. The suggested identification strategy hinges on a novel pre-test for the null of instrument relevance based on bootstrap resampling which is not subject to pre-testing issues. Specifically, the validity of post-test asymptotic inferences remains unaffected by the test outcomes due to an asymptotic independence result between the bootstrap and non-bootstrap statistics. The test is robust to conditionally heteroskedastic and/or zero-censored proxies, is computationally straightforward and applicable regardless of the number of shocks being instrumented. Some illustrative examples show the empirical usefulness of the suggested identification and testing strategy.