Abstract

When in proxy-SVARs the covariance matrix of VAR disturbances is subject to exogenous, permanent, nonrecurring breaks that generate target impulse response functions (IRFs) that change across volatility regimes, even strong, exogenous external instruments can result in inconsistent estimates of the dynamic causal effects of interest if the breaks are not properly accounted for. In such cases, it is essential to explicitly incorporate the shifts in unconditional volatility in order to point-identify the target structural shocks and possibly restore consistency. We demonstrate that, under a necessary and sufficient rank condition that leverages moments implied by changes in volatility, the target IRFs can be point-identified and consistently estimated. Importantly, standard asymptotic inference remains valid in this context despite (i) the covariance between the proxies and the instrumented structural shocks being local-to-zero, as in Staiger and Stock (1997), and (ii) the potential failure of instrument exogeneity. We introduce a novel identification strategy that appropriately combines external instruments with "informative" changes in volatility, thus obviating the need to assume proxy relevance and exogeneity in estimation. We illustrate the effectiveness of the suggested method by revisiting a fiscal proxy-SVAR previously estimated in the literature, complementing the fiscal instruments with information derived from the massive reduction in volatility observed in the transition from the Great Inflation to the Great Moderation regimes.