Flexible Mixture Priors for Large Time-varying Parameter Models (2006.10088v2)

Abstract: Time-varying parameter (TVP) models often assume that the TVPs evolve according to a random walk. This assumption, however, might be questionable since it implies that coefficients change smoothly and in an unbounded manner. In this paper, we relax this assumption by proposing a flexible law of motion for the TVPs in large-scale vector autoregressions (VARs). Instead of imposing a restrictive random walk evolution of the latent states, we carefully design hierarchical mixture priors on the coefficients in the state equation. These priors effectively allow for discriminating between periods where coefficients evolve according to a random walk and times where the TVPs are better characterized by a stationary stochastic process. Moreover, this approach is capable of introducing dynamic sparsity by pushing small parameter changes towards zero if necessary. The merits of the model are illustrated by means of two applications. Using synthetic data we show that our approach yields precise parameter estimates. When applied to US data, the model reveals interesting patterns of low-frequency dynamics in coefficients and forecasts well relative to a wide range of competing models.