Identification and Estimation of Dynamic Causal Effects in Macroeconomics Using External Instruments

External sources of as‐if randomness — that is, external instruments — can be used to identify the dynamic causal effects of macroeconomic shocks. One method is a one‐step instrumental variables regression (local projections – IV); a more efficient two‐step method involves a vector autoregression. We show that, under a restrictive instrument validity condition, the one‐step method is valid even if the vector autoregression is not invertible, so comparing the two estimates provides a test of invertibility. If, however, lagged endogenous variables are needed as control variables in the one‐step method, then the conditions for validity of the two methods are the same.