Economic Forecasting Techniques Flashcards

The Hodrick-Prescott (HP) filter is commonly applied in macroeconomic forecasting to:

Answer: Separate a time series into trend and cyclical components

The HP filter minimizes deviations from a smooth trend, weighted by a smoothing parameter λ, to extract the business cycle component.

Dynamic Factor Models (DFMs) are advantageous for macroeconomic forecasting primarily because they:

Answer: Extract a small number of common factors from a large dataset of economic indicators

DFMs reduce hundreds of economic series to a handful of latent factors, efficiently summarizing co-movement and improving forecast accuracy.

In a GARCH(1,1) model applied to economic forecasting, what does the model primarily capture?

Answer: Time-varying volatility clustering in financial or economic time series

GARCH models capture the empirical regularity that large shocks to an economic series tend to be followed by further large shocks (volatility clustering).

Which evaluation metric is most appropriate when forecast errors are heteroskedastic and large outliers should not be penalized excessively?

Answer: Mean Absolute Error (MAE)

MAE weights all errors equally regardless of size, making it more robust to outliers than RMSE, which squares errors and amplifies large deviations.

An economic forecaster notices that residuals from a regression model are positively autocorrelated. The most appropriate corrective action is to:

Answer: Add lagged dependent or independent variables to capture omitted dynamics

Positive serial correlation in residuals typically signals missing lag structure; adding lags removes the autocorrelation and improves forecast accuracy.

Scenario analysis in economic forecasting differs from sensitivity analysis in that scenario analysis:

Answer: Defines internally consistent sets of assumptions across multiple variables simultaneously

Scenario analysis creates coherent narratives (e.g., a trade war scenario) by jointly changing multiple variables, unlike sensitivity analysis which varies one factor at a time.

The concept of 'forecast encompassing' implies that:

Answer: A forecast cannot be improved by combining it with any competing forecast

A forecast encompasses a rival if adding the rival's forecast to it provides no additional predictive information, meaning all useful information is already captured.