  External-instrument identification leads to biased responses when the shock
is not invertible and the measurement error is present. We propose to use this
identification strategy in a structural Dynamic Factor Model, which we call
Proxy DFM. In a simulation analysis, we show that the Proxy DFM always
successfully retrieves the true impulse responses, while the Proxy SVAR
systematically fails to do so when the model is either misspecified, does not
include all relevant information, or the measurement error is present. In an
application to US monetary policy, the Proxy DFM shows that a tightening shock
is unequivocally contractionary, with deteriorations in domestic demand, labor,
credit, housing, exchange, and financial markets. This holds true for all raw
instruments available in the literature. The variance decomposition analysis
highlights the importance of monetary policy shocks in explaining economic
fluctuations, albeit at different horizons.
