I have dummy variables (DV) which measure policy reforms (e.g. Independence of the judiciary, barriers-to-entry in a market etc.). These can be either “0,1” or, say, “0,1,2,….. upper”.
Say I have a VAR or VECM with these dummies in them. Two problems follow:
Is it legitimate to do impulse responses on dummies? They are after all categorical variables, bound on a given interval. Does a temporary shock to a DV even make sense (=> a policy maker implements a reform, then withdraws it??). And if only permanent reforms make sense, how do you model agents’ learning of the reform since presumably you need to shock the dummy down in each period.
The policy reforms on which the dummies are predicated aren’t exogenous events. They can reflect past poor economic performance, electoral changes etc. And yet the dummies (taken from external databases) are notionally considered exogenous.