A Unique Orthogonal Variance Decomposition

Let e and Σ be respectively the vector of shocks and its variance covariance matrix in a linear system of equations in reduced form. This article shows that a unique orthogonal variance decomposition can be obtained if we impose a restriction that maximizes the trace of A, a positive definite matrix such that e Az = where z is vector of uncorrelated shocks with unit variance. Such a restriction is meaningful in that it associates the largest possible weight for each element in e with its corresponding element in z. It turns out that 2 / 1 Σ = A , the square root of Σ .