Counterfactual Analysis in Macroeconometrics: An Empirical Investigation into the E¤ects of Quantitative Easing

The policy innovations that followed the recent Great Recession, such as unconventional monetary policies, prompted renewed interest in the question of how to measure the e¤ectiveness of such policy interventions. To test policy e¤ectiveness requires a model to construct a counterfactual for the outcome variable in the absence of the policy intervention and a way to determine whether the di¤erences between the realised outcome and the model-based counterfactual outcomes are larger than what could have occurred by chance in the absence of policy intervention. Pesaran & Smith (2014b) propose tests of policy ine¤ectiveness in the context of macroeconometric rational expectations dynamic stochastic general equilibrium models. When we are certain of the speci…cation, estimation of the complete system imposing all the cross-equation restrictions implied by the full structural model is more e¢ cient. But if the full model is misspeci…ed, one may obtain more reliable estimates of the counterfactul outcomes from a parsimonious reduced form policy response equation, which conditions on lagged values, and on the policy measures and variables known to be invariant to the policy intervention. We propose policy ine¤ectiveness tests based on such reduced forms and illustrate the tests with an application to the unconventional monetary policy known as quantitative easing (QE) adopted in the UK. Keywords: Counterfactuals, policy analysis, policy ine¤ectiveness test, macroeconomics, quantitative easing (QE) JEL classi…cation: C18, C54, E65, We are grateful for comments made on earlier versions of this paper by Alex Chudik, Karrar Hussain, Oscar Jorda and Ivan Petrella.