Working Paper: CEPR ID: DP10201
Authors: Raffaella Giacomini
Abstract: Does economic theory help in forecasting key macroeconomic variables? This article aims to provide some insight into the question by drawing lessons from the literature. The definition of "economic theory" includes a broad range of examples, such as accounting identities, disaggregation and spatial restrictions when forecasting aggregate variables, cointegration and forecasting with Dynamic Stochastic General Equilibrium (DSGE) models. We group the lessons into three themes. The first discusses the importance of using the correct econometric tools when answering the question. The second presents examples of theory-based forecasting that have not proven useful, such as theory-driven variable selection and some popular DSGE models. The third set of lessons discusses types of theoretical restrictions that have shown some usefulness in forecasting, such as accounting identities, disaggregation and spatial restrictions, and cointegrating relationships. We conclude by suggesting that economic theory might help in overcoming the widespread instability that affects the forecasting performance of econometric models by guiding the search for stable relationships that could be usefully exploited for forecasting.
Keywords: Bayesian methods; DSGE models; Exponential tilting
JEL Codes: C52; C53
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| choice of econometric methodology (C51) | usefulness of economic theory for forecasting (F37) |
| appropriateness of loss function (C52) | conclusions about usefulness of theoretical restrictions (C90) |
| theoretical restrictions are valid (C20) | forecast accuracy (C53) |
| theory-driven variable selection in univariate forecasting (C29) | forecasting performance (C53) |
| use of estimated DSGE models (E13) | forecasting performance (C53) |
| survey-based forecasts and methods that extract information from large datasets (C53) | short-term forecasting (F37) |
| theory-based cointegrating restrictions (C51) | long-term forecasting (F37) |
| economic theory (D46) | insights into cross-sectional dependence among variables (C21) |