Orthogonalize shocks using a Structural VAR

Hello everyone,

I am working on a Structural VAR model and I do not understand how the short term restrictions are a way to orthogonalize shocks.

I found this paragraph in a presentation on structural VARs

“Impulse response functions are interpreted under the assumption that all the other shocks are held constant. However in the Wold representation the shocks are not orthogonal. So the assumption is not very realistic!

This is why we need Structural VAR in order to perform policy analysis. Ideally we would like to have orthogonal shock”

I don’t understand how the Cholesky identification is a way to make the errors uncorrelated. For instance in the case of a SVAR with 4 variables and 6 restrictions we obtain:

https://imgur.com/nHDG3JR

How do I know that epsilon_1 is uncorrelated with epsilon_2 ?

I hope you can help me

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Nevin Manimala

Nevin Manimala is interested in blogging and finding new blogs https://nevinmanimala.com

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