Comparing the DSGE model
with the factor model:
an out-of-sample forecasting experiment
Mu-Chun Wang
(Johann Wolfgang Goethe University of Frankfurt)
Discussion Paper
Series 1: Economic Studies
No 04/2008
Discussion Papers represent the authors’ personal opinions and do not necessarily reflect the views of the
Deutsche Bundesbank or its staff.
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ISBN 978-3–86558–379–6 (Printversion)
ISBN 978-3–86558–380–2 (Internetversion)
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""(# Non-technical summary
Recently, a growing literature has dealt with forecasting using large factor models. Typically,
the modern factor models extract only a few components (called common factors) representing the
overall economic activities of a large dataset. These factors can then be used to forecast some key
economic variables. Various applications of such models in forecasting macroeconomic and financial
variables claim that forecasts generated from factor models are superior to simple time series
benchmark models. A totally different approach to forecast economic variables is to specify and
estimate a dynamic stochastic general equilibrium (DSGE) model. DSGE models have recently
become popular in terms of policy analysis because they are very useful storytelling devices due to
their rigorous microeconomic foundations. In this paper, we put DSGE forecasts in competition with
factor forecasts. We focus on these two models since they represent nicely the two opposing
forecasting philosophies. The DSGE model, on the one hand, has a strong theoretical economic
background. The factor model, on the other hand, is mainly data-driven. In addition, unrestricted
vector autoregressive (VAR) and simple univariate autoregressive (AR) models are considered as
benchmark models. We implement out-of-sample forecasting experiments, using the aforementioned
models, on output growth and inflation in the US economy on a quarterly basis.
The underlying factor forecasting model is the diffusion indexes model (DI) proposed by
Stock and Watson (2002b). The DI model produces direct multistep forecasts without having to
specify the dynamics of the factors explicitly. We collect, in total, 83 macroeconomic and financial
series and use the static principle component method to extract the factors. The underlying DSGE
model is a prototypical monetary New-Keynesian model proposed by Del Negro and Schorfheide
(2004). The estimation of the DSGE model is carried out using the Bayesian framework.
Regarding the informativeness of forecasts, model-based output growth forecasts are generally
not informative for forecast horizons exceeding one year. However, inflation forecasts computed from
the models are vastly informative at every forecast horizon. In terms of the forecasting performance
measured in mean squared forecast errors, the factor model is, in general, superior to any other model
in the short run. The DSGE model is able to outperform the unrestricted VAR. However, the VAR
turns out to be an unreliable benchmark since it is, in most cases, the worst forecasting model.
To a certain extent our results are consistent with the prevailing view that time series models
should be used in short-horizon forecasting and structural models should be used in long-horizon
forecasting. Our paper closes the existing gap in the literature which up to now has investigated the
predictive ability of data-driven factor models and theoretical DSGE models separately from each
other.
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1
2
3
4
5
6
7
8
9
10
11
12
13
Prices
cpiuaa_us
cpiuac_us
cpiuad_us
cpiuam_us
cpiuas_us
cpiuat_us
cpiul1_us
cpiul2_us
cpiul5_us
ppisp1000_us
ppisp2000_us
ppisp3000_us
ppisp3100_us
cpi: urban consumer - apparel, (1982-84=100, sa)
cpi: urban consumer - commodities, (1982-84=100, sa)
cpi: urban consumer - durables, (1982-84=100, sa)
cpi: urban consumer - medical care, (1982-84=100, sa)
cpi: urban consumer - services, (1982-84=100, sa)
cpi: urban consumer - transportation, (1982-84=100, sa)
cpi: urban consumer - all items less food, (1982-84=100, sa)
cpi: urban consumer - all items less shelter, (1982-84=100, sa)
cpi: urban consumer - all items less medical care, (1982-84=100, sa)
ppi: stage of processing - crude materials, (index 1982=100, sa)
ppi: stage of processing - intermediate materials, (index 1982=100, sa)
ppi: stage of processing - finished goods, (index 1982=100, sa)
ppi: stage of processing - finished consumer goods, (index 1982=100, sa)
4
4
4
4
4
4
4
4
4
4
4
4
4
14
15
16
17
18
Consumption
uscdtan_b
uscondurb
usconndrb
usconsrvb
usperconb
pce - durables, new autos (ar) cura
personal consumption expenditures - durables (ar) cura
personal consumption expenditures - nondurables (ar) cura
personal consumption expenditures - services (ar) cura
personal consumption expenditures (ar) cura
3
3
3
3
3
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
Employment
usem21__o
usem23__o
usem42__o
usem81__o
usemig__o
usemimd_o
usemip__o
usemir__o
usemit__o
usempallo
usempg__o
usempmano
usemps__o
usemptoto
ushlpwadq
usun_totq
usundurne
usunw14_q
usunw15_q
usunw26_q
usunw5__q
usvactoto
employed - mining vola
employed - construction vola
employed - wholesale trade vola
employed - otherservices vola
employed - government vola
employed - durable goods vola
employed - totalprivate vola
employed - retail trade vola
employed - trade, transportation, & utilities vola
employed - nonfarm industries total (payroll survey) vola
employed - goods-producing vola
employed - manufacturing vola
employed - service-providing vola
total civilian employment vola
help wanted-proportion of labor markets w/rising want-ad vola
unemployment rate sadj
average durationof unemployment (weeks) vola
unemployed distribution - 5 to 14 weeks sadj
unemployed distribution - 15 weeks & over sadj
unemployed distribution - 15 to 26 weeks & over sadj
unemployed distribution - less than 5 weeks sadj
index of help wanted advertising vola
3
3
3
3
3
3
3
3
3
3
3
3
3
3
1
2
1
1
1
1
1
3
41
42
43
44
45
Housing
ushbrm__o
ushbrn__o
ushbrs__o
ushbrw__o
ushouse_o
housing started - midwest (ar) vola
housing started - northeast (ar) vola
housing started - south (ar) vola
housing started - west (ar) vola
new private housing units started (ar) vola
3
3
3
3
3
46
47
48
49
Hours and earnings
ushkim__o
ushxpmano
uswr23__b
uswrim__b
avg wkly hours -manufacturing vola
avg overtime hours - manufacturing vola
avg hrly earn -construction cura
avg hrly earn -manufacturing cura
3
3
4
4
50
51
52
53
54
55
56
57
58
59
60
61
Output and income
usipmbuqg
usipmcogg
usipmducg
usipmfgsg
usipmfing
usipmmatg
usipmnocg
usipmprog
usiptot_g
usiumfgsq
uspdispib
uspersinb
indl prod - business equipment vola
indl prod - consumer goods vola
indl prod - durable consumer goods vola
industrial production - manufacturing (sic) vola
indl prod - final products, total vola
indl prod - materials, total vola
indl prod - nondurable consumer goods vola
indl prod - final products & nonindustrial supplies vola
industrial production - total index vola
indl utilization- manufacturing (sic) sadj
disposable personal income (ar) cura
personal income (ar) cura
3
3
3
3
3
3
3
3
3
1
3
3
62
63
64
65
66
67
68
69
70
71
72
73
74
75
Interest rates
uscrbbaa
uscrbyld
ustrb3av
ustrcn10
ustrcn1_
ustrcn5_
usytb6sm
ussfycrbyld
ussfycrbbaa
ussfytrb3av
ussfyytb6sm
ussfytrcn1_
ussfytrcn10
ussfytrcn5_
corporate bond yield - moody's baa, seasoned issues
corporate bond yield - moody's aaa, seasoned issues
treasury bill secondary market rate on discount basis-3 month
treasury yield adjusted to constant maturity - 10 year
treasury yield adjusted to constant maturity - 1 year
treasury yield adjusted to constant maturity - 5 year
treasury bill secondary market rate on discount basis-6 month
spread uscrbyld - federal funds
spread uscrbbaa - federal funds
spread ustrb3av - federal funds
spread usytb6sm - federal funds
spread ustrcn1_ - federal funds
spread ustrcn10 - federal funds
spread ustrcn5_ - federal funds
2
2
2
2
2
2
2
1
1
1
1
1
1
1
76
77
78
79
80
81
82
83
Other
usm0____b
usnbrrsab
uspmchin
uspmchlt
uspmchp_
ustotrsab
usexpgdsb
uscnfbusq
monetary base cura
nonborrowed reserves of depository institutions cura
chicago purchasingmanager diffusion index-inventories(sa)
chicago purchasingmanager diffusion index-deliveries(sa)
chicago purchasingmanager diffusion index-prodn. (sa) sadj
total reserves of depository institutions cura
exports f.a.s. cura
ism purchasing managers index (mfg survey) sadj
4
3
1
1
1
3
3
1
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-=: 6HHD8>6I:9 I:HI HI6I>HI>8 >H 6C9 =:C8: H><C>P86CI 6I ><JG: !6>C &DHH >C ', H BD9:AH K:GHJH JC8DC9>I>DC6A B:6C
Output Growth
0.4
0.2
0
-0.2
DSGE
AR
VAR
DI
-0.4
-0.6
1
2
3
4
5
6
7
8
9
10
11
12
7
8
9
10
11
12
Inflation
0.8
0.6
0.4
0.2
0
-0.2
1
2
3
4
5
6
><JG: !6>C &DHH >C ', H # K:GHJH +
Output Growth
0.4
0.3
0.2
0.1
0
-0.1
1
2
3
4
5
6
7
8
9
10
11
12
7
8
9
10
11
12
Inflation
0.2
0.1
0
BIC
k=1
k=2
k=3
k=4
-0.1
-0.2
-0.3
-0.4
1
2
3
4
5
6
><JG: !6>C &DHH >C ', H ,! K:GHJH /+
Output Growth
0.4
0.3
0.2
0.1
0
-0.1
-0.2
1
2
3
4
5
6
7
8
9
10
11
12
Inflation
0.6
0.5
0.4
BIC
p=1
p=2
p=3
p=4
0.3
0.2
0.1
0
1
2
3
4
5
6
7
8
9
10
11
12
The following Discussion Papers have been published since 2007:
Series 1: Economic Studies
01
2007
The effect of FDI on job separation
Sascha O. Becker
Marc-Andreas Mündler
02
2007
Threshold dynamics of short-term interest rates:
empirical evidence and implications for the
Theofanis Archontakis
term structure
Wolfgang Lemke
03
2007
Price setting in the euro area:
some stylised facts from individual
producer price data
Dias, Dossche, Gautier
Hernando, Sabbatini
Stahl, Vermeulen
04
2007
Unemployment and employment protection
in a unionized economy with search frictions
Nikolai Stähler
05
2007
End-user order flow and exchange rate dynamics S. Reitz, M. A. Schmidt
M. P. Taylor
06
2007
Money-based interest rate rules:
lessons from German data
C. Gerberding
F. Seitz, A. Worms
07
2007
Moral hazard and bail-out in fiscal federations:
evidence for the German Länder
Kirsten H. Heppke-Falk
Guntram B. Wolff
08
2007
An assessment of the trends in international
price competitiveness among EMU countries
Christoph Fischer
Reconsidering the role of monetary indicators
for euro area inflation from a Bayesian
perspective using group inclusion probabilities
Michael Scharnagl
Christian Schumacher
09
10
2007
2007
A note on the coefficient of determination in
Jeong-Ryeol Kurz-Kim
regression models with infinite-variance variables Mico Loretan
27
11
2007
Exchange rate dynamics in a target zone a heterogeneous expectations approach
Christian Bauer
Paul De Grauwe, Stefan Reitz
12
2007
Money and housing evidence for the euro area and the US
Claus Greiber
Ralph Setzer
13
2007
An affine macro-finance term structure model
for the euro area
Wolfgang Lemke
14
2007
Does anticipation of government spending matter? Jörn Tenhofen
Evidence from an expectation augmented VAR Guntram B. Wolff
15
2007
On-the-job search and the cyclical dynamics
of the labor market
Michael Krause
Thomas Lubik
16
2007
Heterogeneous expectations, learning and
European inflation dynamics
Anke Weber
17
2007
Does intra-firm bargaining matter for
business cycle dynamics?
Michael Krause
Thomas Lubik
18
2007
Uncertainty about perceived inflation target
and monetary policy
Kosuke Aoki
Takeshi Kimura
19
2007
The rationality and reliability of expectations
reported by British households: micro evidence James Mitchell
from the British household panel survey
Martin Weale
20
2007
Money in monetary policy design under
uncertainty: the Two-Pillar Phillips Curve
versus ECB-style cross-checking
21
2007
Günter W. Beck
Volker Wieland
Corporate marginal tax rate, tax loss carryforwards
and investment functions – empirical analysis
using a large German panel data set
Fred Ramb
28
22
2007
Volatile multinationals? Evidence from the
labor demand of German firms
Claudia M. Buch
Alexander Lipponer
23
2007
International investment positions and
Michael Binder
exchange rate dynamics: a dynamic panel analysis Christian J. Offermanns
24
2007
Testing for contemporary fiscal policy discretion
with real time data
Ulf von Kalckreuth
Guntram B. Wolff
25
2007
Quantifying risk and uncertainty
in macroeconomic forecasts
Malte Knüppel
Karl-Heinz Tödter
26
2007
Taxing deficits to restrain government
spending and foster capital accumulation
Nikolai Stähler
27
2007
Spill-over effects of monetary policy – a progress
report on interest rate convergence in Europe
Michael Flad
28
2007
The timing and magnitude of exchange rate
overshooting
29
2007
The timeless perspective vs. discretion: theory and
monetary policy implications for an open economy Alfred V. Guender
30
2007
International cooperation on innovation: empirical Pedro Faria
evidence for German and Portuguese firms
Tobias Schmidt
31
2007
Simple interest rate rules with a role for money
M. Scharnagl
C. Gerberding, F. Seitz
32
2007
Does Benford’s law hold in economic
research and forecasting?
Stefan Günnel
Karl-Heinz Tödter
33
2007
The welfare effects of inflation:
a cost-benefit perspective
Karl-Heinz Tödter
Bernhard Manzke
29
Hoffmann
Sondergaard, Westelius
34
2007
Factor-MIDAS for now- and forecasting with
ragged-edge data: a model comparison for
German GDP
Massimiliano Marcellino
Christian Schumacher
35
2007
Monetary policy and core inflation
Michele Lenza
01
2008
Can capacity constraints explain
asymmetries of the business cycle?
Malte Knüppel
Communication, decision-making and the
optimal degree of transparency of monetary
policy committees
Anke Weber
02
2008
03
2008
The impact of thin-capitalization rules on
Buettner, Overesch
multinationals’ financing and investment decisions Schreiber, Wamser
04
2008
Comparing the DSGE model with the factor model:
an out-of-sample forecasting experiment
Mu-Chun Wang
30
Series 2: Banking and Financial Studies
01
2007
Granularity adjustment for Basel II
Michael B. Gordy
Eva Lütkebohmert
02
2007
Efficient, profitable and safe banking:
an oxymoron? Evidence from a panel
VAR approach
Michael Koetter
Daniel Porath
03
2007
Slippery slopes of stress: ordered failure
events in German banking
Thomas Kick
Michael Koetter
04
2007
Open-end real estate funds in Germany –
C. E. Bannier
genesis and crisis
F. Fecht, M. Tyrell
Diversification and the banks’
risk-return-characteristics – evidence from
loan portfolios of German banks
A. Behr, A. Kamp
C. Memmel, A. Pfingsten
05
2007
06
2007
How do banks adjust their capital ratios?
Evidence from Germany
Christoph Memmel
Peter Raupach
07
2007
Modelling dynamic portfolio risk using
risk drivers of elliptical processes
Rafael Schmidt
Christian Schmieder
08
2007
Time-varying contributions by the corporate bond
and CDS markets to credit risk price discovery Niko Dötz
09
2007
Banking consolidation and small business
finance – empirical evidence for Germany
K. Marsch, C. Schmieder
K. Forster-van Aerssen
10
2007
The quality of banking and regional growth
Hasan, Koetter, Wedow
11
2007
Welfare effects of financial integration
Fecht, Grüner, Hartmann
12
2007
The marketability of bank assets and managerial Falko Fecht
rents: implications for financial stability
Wolf Wagner
31
13
2007
Asset correlations and credit portfolio risk –
an empirical analysis
K. Düllmann, M. Scheicher
C. Schmieder
14
2007
Relationship lending – empirical evidence
for Germany
C. Memmel
C. Schmieder, I. Stein
15
2007
Creditor concentration: an empirical investigation S. Ongena, G.Tümer-Alkan
N. von Westernhagen
16
2007
Endogenous credit derivatives and bank behaviour Thilo Pausch
17
2007
Profitability of Western European banking
systems: panel evidence on structural and
cyclical determinants
Rainer Beckmann
Estimating probabilities of default with
support vector machines
W. K. Härdle
R. A. Moro, D. Schäfer
18
2007
32
Visiting researcher at the Deutsche Bundesbank
The Deutsche Bundesbank in Frankfurt is looking for a visiting researcher. Among others
under certain conditions visiting researchers have access to a wide range of data in the
Bundesbank. They include micro data on firms and banks not available in the public.
Visitors should prepare a research project during their stay at the Bundesbank. Candidates
must hold a Ph D and be engaged in the field of either macroeconomics and monetary
economics, financial markets or international economics. Proposed research projects
should be from these fields. The visiting term will be from 3 to 6 months. Salary is
commensurate with experience.
Applicants are requested to send a CV, copies of recent papers, letters of reference and a
proposal for a research project to:
Deutsche Bundesbank
Personalabteilung
Wilhelm-Epstein-Str. 14
60431 Frankfurt
GERMANY
33