Bayesian Inference of Local Projections with Roughness Penalty Priors
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A local projection is a statistical framework that accounts for the relationship between an exogenous variable and an endogenous variable, measured at different time points. Local projections are often applied in impulse response analyses and direct forecasting. While local projections are becoming increasingly popular owing to their robustness to misspecification and their flexibility, they are less statistically efficient than standard methods, such as vector autoregressions. In this study, we seek to improve the statistical efficiency of local projections by developing a fully Bayesian approach that can be used to estimate local projections using roughness penalty priors. Then, we apply the proposed approach to an analysis of monetary policy in the United States, showing that the roughness penalty priors successfully estimate the impulse response functions and improve the predictive accuracy of the local projections.
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