Forecasting with Factor-Augmented Error Correction Models

46 Pages Posted: 10 Feb 2010

See all articles by Anindya Banerjee

Anindya Banerjee

European University Institute - Department of Economics; University of Oxford - Department of Economics

Massimiliano Giuseppe Marcellino

Bocconi University - Department of Economics; Centre for Economic Policy Research (CEPR)

Igor Masten

University of Ljubljana - Faculty of Economics

Date Written: February 2010

Abstract

As a generalization of the factor-augmented VAR (FAVAR) and of the Error Correction Model (ECM), Banerjee and Marcellino (2009) introduced the Factor-augmented Error Correction Model (FECM). The FECM combines error-correction, cointegration and dynamic factor models, and has several conceptual advantages over standard ECM and FAVAR models. In particular, it uses a larger dataset compared to the ECM and incorporates the long-run information lacking from the FAVAR because of the latter's specification in differences. In this paper we examine the forecasting performance of the FECM by means of an analytical example, Monte Carlo simulations and several empirical applications. We show that relative to the FAVAR, FECM generally offers a higher forecasting precision and in general marks a very useful step forward for forecasting with large datasets.

Keywords: Cointegration, Dynamic Factor Models, Error Correction Models, Factor-augmented Error Correction Models, FAVAR, Forecasting

JEL Classification: C32, E17

Suggested Citation

Banerjee, Anindya and Marcellino, Massimiliano and Masten, Igor, Forecasting with Factor-Augmented Error Correction Models (February 2010). CEPR Discussion Paper No. DP7677, Available at SSRN: https://ssrn.com/abstract=1550589

Anindya Banerjee (Contact Author)

European University Institute - Department of Economics ( email )

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University of Oxford - Department of Economics ( email )

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Massimiliano Marcellino

Bocconi University - Department of Economics ( email )

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Milan, 20136
Italy

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Igor Masten

University of Ljubljana - Faculty of Economics ( email )

Kardeljeva ploscad 17
Ljubljana, 1000
Slovenia

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