FRIDAY Seminar: What Impulse Response Do Instrumental Variables Identify?

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This paper addresses the limitations of the local projection IV (LP-IV) framework in identifying impulse responses to macroeconomic shocks. We show that an LPIV estimand may lack a causal interpretation, as it represents a weighted average of component-wise impulse responses, potentially with negative weights. These negative weights arise when the IV and shock components exhibit opposite signs of correlation. To address these limitations, we develop novel identification strategies using additional disaggregated variables or sign restrictions, particularly in the presence of multiple IVs. Our approach combines multiple LP-IV estimands with sign restrictions to construct identified sets for component-wise impulse responses. In contrast, conventional methods such as two-stage least squares (2SLS) fail to identify structural parameters in this context, and the identified set may be unbounded, challenging the validity of Bayesian approaches. We illustrate the practical significance of our findings through a detailed analysis of government spending multipliers and monetary policy shocks, highlighting the importance of accounting for the composite nature of macroeconomic shocks in policy analysis.