; TIME SERIES ECONOMETRICS: ) FORECASTING We noted in the Introduction th 1 n at forecasting is an important part of econometric analysis, for some people probably the most important. How do we forecast economic variables, such as GDP, inflation, exchange rates, stock prices, unemployment rates, and myriad other economic variables? In this chapter we discuss two methods of forecasting that have become quite Popular: (1) autoregressive integrated moving average (ARIMA), popu- __ larly known as the Box-Jenkins methodology,' and (2) vector autoregres- sion (VAR), In this chapter we also discuss the special problems involved in forecast: ing prices of financial assets, such as stock prices and exchange rates. These “asset prices are characterized by the phenomenon known as volatility ~ clustering, that is, periods in which they exhibit wide swings for an ex. ~~ tended time period followed by a period of comparative tranquility. One only has to look at the Dow Jones Index in the recent past. The so-called auto- rn fe conditional heteroscedasticity (ARCH) or generalized au- toregres conditional heteroscedasticity (GARCH) models can cap- ture such volatility clustering. oe Ipta bk acme feces intial speciatind Books have been non this subject. Our objective in this chapter is to give the reader just of this subject. The interested reader may consult the references Fortunately, most modern econometric packages have aes z eral techniques discussed in this chapter. Control, revised ed., 855ter and the previous chapter is that the . ow ‘assume that the underlying time tionary with appropriate ‘i stati hey can be made stationary with trans. Re ope through this chapter, you will see the use of the. several. concepts that we introduced in the last chapter. ‘The linkage between thi forecasting methods discusse 2.1 APPROACHES TO ECONOMIC FORECASTING o P roadly speaking, there are five approaches to economic forecasting based i oe wee iste: qa) exponential smoothing methods, (2) single-equation regression models, (3) ‘simultaneous-equation regression models, (4) autore._ gressive integrated moving average models (ARIMA), and (5) vector auttore. gression, xponential Smoothing Methods? These are essentially methods of fitting a suitable curve to historical data of a given time series. There are a variety of these methods, such as single exponential smoothing, Holt’ linear method, and Holt-Winters' method and their variations. Although still used in several areas of business and eco- nomic forecasting, these are now supplemented (supplanted?) by the other four methods mentioned previously. We will not discuss them in this chap- ter, for that would take us far afield. ingle-Equation Regression Models i The bulk of this book has been devoted to single-equation regression mod- = es an eae of ‘. ee model, consider the demand fune- ion for automobiles. On the basis of economic theory, we postulate that the F demand for automobiles is a function of DARE Giiees, advertising ex- stint penditure, income of the consumer, interest rate (as a measure of the cost of Poppe 2 other relevant variables (e.g., family size, travel distance to work). ba tana es data, we estimate an appropriate model of auto de- mand ee ; log-linear or nonlinear), which can be used for fore- . casting demand or autos in the future. Of course, as noted in Chapter 5. . forecasting errors increase rapidly if we go too far out in the future. ont ed simultaneous-equation models. aun elaborate models of the US. Steven C. “id ed., John Wiley a! a bi eeing. But since then the glamor of such forecasting models has subsided be- FE cause of their poor forecasting performance, Seesell ee the 1973 and 1979 oil price shocks (due to OPEC oil embargoes) ‘and also because of the so-called Lucas critique.’ The thrust of this critique, as you may recall, is that the parameters estimated from an econometric model are dependent on the policy prevailing at the time the model was estimated and will chang® if there is a policy change. In short, the estimated parameters are not in- variant in the presence of policy changes. | For example, in October 1979 the Fed changed its monetary policy dra- matically, Instead of targeting interest rates, it ‘announced it would hence- | forth monitor the rate of growth of the money supply. With such a pro- nounced change, an econometric model estimated from past data will have little forecasting value in the new regime. These days the Fed’s emphasis has changed from controlling the money supply to controlling the short-term interest rate (the federal funds rate). economy based si Le iy on simultaneous equations dominated economic forecast | The publication Analysis: Forecasting and Control (op. cit.) ing tools. Popularly known as the Box—Jenkins (BJ) methodology, but i ARIMA methodology, the ‘emphasis of these meth single-equation or simultaneous-equation models abilistic, or stochastic, properties ‘of economic time series on their own’ i Io ere dt sea or theses, Unk te eeresion explain ied by k regressor Xt» fay XS nner Xke j-type time se- Sy ecplained by past, or lagged, values of Y itself and , ARIMA models are sometimes derived a any economic theory— Le jon models. 7 me Chee as i univariate ARIMA af models, ‘that is, ARIMA Rose aaaty yt oer si be extended eran esr emlnyNotice that in all the values are involved; the the “data speak for the: swe encountered in eating models only the current and previous ¥ ine No other regressors. In this sense, we say that ee ives." They are a kind of reduced form model that ‘scussion of the simultaneous-equation models. (MA) Process soig arorace (A) The AR process just discussed is not the only i sl erated Y. Suppose we model Y as iat ly mechanism that may have g Ye= e+ Pot + Btw (22.2.4) where 1 is a constant and u, as before, is the white noise stochastic error term. Here Y at time ¢ is equal to a constant plus a moving average of the current and past error terms. Thus, in the present case, we say that ¥ follows, a first-order moving average, or an MA(1), process. But if ¥ follows the expression. Ye = + Botle + Bites + Bathe-2 (22.2.5) then it is an MA(2) process. More generally, x Ye =e + Bote + Biter + Bete 2 toe + Bytleg (22.2.6) is. an MA(q) process. In short, a moving average process is simply a linear combination of white noise error terms. An Autoregressive and Moving Average (ARMA) Process Of course, it is quite likely that Y has characteristics of both AR and MA . find fs therefore ARMA. Thus, ¥; follows an ARMA(1, 1) process if it can be Mibalh Sitne rm Ye =O ban Yin + Bote + Bites (22.2.7) ‘autoregressive and one moving average term. In there will be p autoregressive and4 MAGROECONOMICS DATA, UNITED STATES, 1970-170 1991-1 Por PCE «Profits. Dividend Quanter Gop rome d tgvos 700s 44.7245 1981-1 a " 1807S 444 23. 3860.5, (eons 2045.3 18247 44.8 Fa) enna ee ee : e mss ety : Sa 67 24761 1437 ; ; er aay 4 3854.5 2614.1 2487 goi9 0739 18499 488 238 SBI Sapa e083 ae8ee 1403 , Bees 20000 18635 507 ©9237 {Oz 9756-1 27050 2406.0 fe 70 : Nose teres S42 (2 377 papel : Boas 2121.1 19045 85.7 ee 1982-1 3758.4 Sec neasee yas eS ee ewrerti nest mee eens 10s | 728 goso7 2149.1 19633 60.1 28 1908} areas e438 = ie 31258 21939 19891 62 i Ml 3886. ie ae Set So es es ees eel a ee ee 2 : Tea Sauda 0080 26990 4s 7 BS 32593 29007 20639 79.1 27.0 : 6 26782 1416 842 goe76 23152 20620 812 278 1984-1 4089.5 3033.2 Yereill 92643 23379 20737 813 28.3 104 41440 OpeSO!- Suit IeE6 ee 1973-1V son oe 20674 no “ps tects sis sey eee yay 92594 20947 2050.8 2 3185 2 : jareil 32678 23045 20590 een 1985-1 4221.8 91236 See Geared fori $2991 2315.0 20655 97.1 a Teel coske Seis omer jee GOR Torey 32264 2313.7 20009 868 See Pi pated i 9154.0 22825 2051.8 758 : 85M Kaas St7e7 aieea one ora 31904 2390.3 2086.9 owes, 1986-1 4390.5 322 : 32499 81.0 297 1986-1! . 7.5 29224 1092 105.1 23544 21144 97.8 30.1 4987.7 3281.4 20479 1 32925 2389.4 2197.0 1034 30, jose i4i26 sore om0a7 1ni0 1123 50567 24245 21793 1084 eee daar eee res ties to | 39682 24949 21947 1092 eo 1887-1 44600 saa52 IIS 140 oo Reeios seer cea» 110.0 350. feer-ll 45153 weat7 Ae is7) 1055 Mies 24695 22420 1103 38s «IOS eeess 38080 S074 tent 1084 sage er 46255 33358 30748 1760 1063 35250 es ee co ee ee 9380.1 3128.2 1955 1096 Sa Goo z2s tet aid (emmy macs aes je a IN 47345 34075 91706 2134 1175 gees ae 4988-IV 47797 3443.1 32029 2260 121.0 5 198c-1 4809.8 3200. 1540 © 445 1980-4 482.4 3h Ge oe er ie) 466 1980-Ill_ 4845.6 24669 241.1 1987 429.4 ; 8 489 4989-IV 4859.7 3493.0 3241.6 203.0 190.7 oa2 50S «= «1900-1 48808 Said go58e 1981 192. 474.1 51.8 «1990-1 4900.3 9545.9 32586 oy ee 1781 52.7 4990-1 49033 3547.0 32812 1969 1338 54.5 4990-IV. 4855.1 3529.5. 9251.8 199.0 57.6 y9gi-1 4824.0 3514.8 9241.1 189.7 58.7 4991-1 92524 182.7 1898 4991-iIl 4991-1V