How Well Are State-Dependent Local Projections Capturing Nonlinearities?

Abstract

We use quadratic vector autoregressions, motivated by pruned second-order perturbation solutions to DSGE models, as a laboratory to evaluate how well popular local projection (LP) specifications recover true impulse responses in nonlinear environments. We derive closed-form population impulse responses under each specification and compare them to truth. Linear LP fails to capture nonlinearities when the shock is symmetrically distributed. State-dependent LP specifications capture distinct aspects of nonlinearity: interacting the shock with its sign captures asymmetric effects, while interacting the shock with observable state proxies captures state dependence. However, their gains over linear LP are concentrated in tail shocks or states, and for the latter depend on proxy quality. Our proposed specification -- augmenting linear LP with a squared shock term and shock-state proxy interactions -- best approximates true responses. We also establish valid estimation and inference procedures for this specification. In a monetary policy application, we find state dependence, while higher-order effects differ across outcomes.