Theory Coherent Shrinkage of Time-Varying Parameters in VARs

This article introduces a theory coherent shrinkage prior for Time-Varying Parameter VARs (TVP-VARs). The prior centers the time-varying parameters on a path implied a priori by an underlying economic theory, chosen to describe the dynamics of the macroeconomic variables in system. Leveraging information from conventional economic theory using this prior significantly improves inference precision and forecast accuracy compared to the standard TVP-VAR. In an application, I leverage information from a New Keynesian model that incorporates both the Zero Lower Bound (ZLB) and forward guidance to address the inferential challenges faced by the standard TVP-VAR model during the ZLB period. This approach leads to more precise estimates of the impulse response functions, revealing a distinct propagation of risk premium shocks inside and outside the ZLB in U.S. data.