Conditioning on Observables vs Shocks¶

Conditioning Approaches: Observables vs. Shocks¶

Conditional forecasting and scenario analysis distinguish between conditioning on observables and conditioning on shocks.

Conditioning on Observables¶

This is the approach implemented when using reduced-form VARs where the contemporaneous relationship between variables is not estimated.

• Definition:
  Conditioning on observables means imposing constraints directly on the future paths of observed variables (e.g., GDP, inflation). For example, you might require that inflation follows a specific trajectory over the forecast horizon.
• Implementation:
  This is typically done by specifying a set of linear restrictions on the forecasted values of the endogenous variables.
• Interpretation:
  The model finds the distribution of shocks and parameter draws that are consistent with the imposed path for the observables, without specifying which shocks are responsible for achieving the scenario.
• Use case:
  Useful for scenario analysis where the focus is on the outcome (e.g., "What if inflation is 2% next year?"), regardless of the underlying structural drivers.

Conditioning on Shocks¶

Reduced-form VARs cannot impose this restriction because the analyst must estimate the contemporaneous relationship between variables and their causes.

• Definition:
  Conditioning on shocks means specifying the path of one or more structural shocks (e.g., a monetary policy shock, a supply shock) over the forecast horizon.
• Implementation:
  The model imposes constraints on the sequence of structural shocks, and then computes the implied path for the observables. This requires identification of the structural shocks (e.g., via SVARs).
• Interpretation:
  The resulting forecast shows the evolution of observables that would occur if the specified shocks materialize, holding all other shocks at their typical (zero) values.
• Use case:
  Useful for policy analysis or counterfactuals (e.g., "What would happen to output and inflation after a sequence of negative supply shocks?").

Key Difference¶

• Condition-on-observables answers:
  "What happens if the interest rate is at the ZLB for the next year?"
• Condition-on-shocks answers:
  "What happens if a monetary policy shock brings the interest rate to the ZLB for the next year?"

Reference:
Antolín-Díaz, J., Petrella, I., & Rubio-Ramírez, J. F. (2021). Structural scenario analysis with SVARs.