Disentangling demand and supply shocks in the crude oil market : how to check sign restrictions in structural VARs

Abstract

Sign restrictions have become increasingly popular for identifying shocks in structural vector autoregressive (SVAR) models. So far there are no techniques for validating the shocks identified via such restrictions. Although in an ideal setting the sign restrictions specify shocks of interest, sign restrictions may be invalidated by measurement errors, data adjustments or omitted variables. We model changes in the volatility of the shocks via a Markov switching (MS) mechanism and use this device to give the data a chance to object to sign restrictions. The approach is illustrated by considering a small model for the market of crude oil. Earlier findings that oil supply shocks explain only a very small fraction of movements in the price of oil are confirmed and it is found that the importance of aggregate demand shocks for oil price movements has declined since the mid 1980s.