Research Discussion Papers, Bank of Finland
No 21/2005:
Forecasting with a forward-looking DGE model: combining long-run views of financial markets with macro forecasting
Hanna-Leena Männistö ()
Abstract: To develop forecasting procedures with a forward-looking
dynamic general equilibrium model, we built a small New-Keynesian model and
calibrated it to euro area data. It was essential in this context that we
allowed for long-run growth in GDP. We brought additional asset price
equations based on the expecta-tions hypothesis and the Gordon growth
model, into the standard open economy model, in order to extract
information on private sector long-run expectations on fundamentals, and to
combine that information into the macro economic forecast. We propose a
method of transforming the model in forecasting use in such a way, as to
match, in an economically meaningful way, the short-term forecast levels,
especially of the model's jump-variables, to the parameters affecting the
long-run trends of the key macroeconomic variables. More specifically, in
the model we have used for illustrative purposes, we pinned down the
long-run inflation expectations and domestic and foreign potential
growth-rates using the model's steady state solution in combination with,
by assumption, forward looking information in up-to-date financial market
data. Consequently, our proposed solution preserves consistency with market
expectations and results, as a favourable by-product, in forecast paths
with no initial, first forecast period jumps. Further-more, no ad hoc
re-calibration is called for in the proposed forecasting procedures, which
clearly is an advantage from point of view of transparency in
communication.
Keywords: forecasting; New Keynesian model; DSGE model; rational expectations; open economy; (follow links to similar papers)
JEL-Codes: E17; E30; E31; F41; (follow links to similar papers)
58 pages, October 11, 2005
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