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Large-Dimensional Dynamic Factor Models: Estimation of Impulse-Response Functions with $I(1)$ Cointegrated Factors

We study a large-dimensional Dynamic Factor Model where: (i)~the vector of factors $\mathbf F_t$ is $I(1)$ and driven by a number of shocks that is smaller than the dimension of $\mathbf F_t$; and, (ii)~the idiosyncratic components are either $I(1)$ or $I(0)$. Under~(i), the factors $\mathbf F_t$ are cointegrated and can be modeled as a Vector Error Correction Model (VECM). Under (i) and (ii), we provide consistent estimators, as both the cross-sectional size $n$ and the time dimension $T$ go to infinity, for the factors, the loadings, the shocks, the coefficients of the VECM and therefore the Impulse-Response Functions (IRF) of the observed variables to the shocks.~Furthermore: possible deterministic linear trends are fully accounted for, and the case of an unrestricted VAR in the levels $\mathbf F_t$, instead of a VECM, is also studied. The finite-sample properties the proposed estimators are explored by means of a MonteCarlo exercise. Finally, we revisit two distinct and widely studied empirical applications. By correctly modeling the long-run dynamics of the factors, our results partly overturn those obtained by recent literature. Specifically, we find that: (i) oil price shocks have just a temporary effect on US real activity; and, (ii) in response to a positive news shock, the economy first experiences a significant boom, and then a milder recession.