Editor’s note: This post is part of a series showcasing Barcelona GSE master projects by students in the Class of 2015. The project is a required component of every master program.
Jorge Meliveo and Willy Scherrieble
Macroeconomic Policy and Financial Markets
In this paper we use a structural Factor Augmented VAR (FAVAR) approach to estimate the effects of news shocks in a new institutional setting: the United Kingdom. We define news shocks as the stock price shock orthogonal to TFP that maximizes the forecast error variance of TFP at the 40 quarter horizon. We find that news shocks account for around 18 – 45% of the variance in output at business cycle frequencies. Furthermore, the predictions of our estimation are in line with the predictions of standard neoclassical business cycle theories, i.e. following a positive news shock, agents increase both consumption and leisure, hence, reducing the amount of hours worked. Our contribution is twofold: First, we enlarge the geographical investigation of the news shock literature by considering a new dataset for the UK. This is important since all major studies have exclusively focused on the US economy so far. Second, we address the problem of non-fundamentalness by comparing a VAR and FAVAR approach. We find that including factors to the VAR changes the results and generates negative co-movement between hours worked and consumption on impact. Furthermore, our results are in line with the findings of Barsky and Sims (2011) and Forni, Gambetti, and Sala (2014) for the US.