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Forecasting with a Bayesian DSGE Model: An Application to the Euro Area

  • Frank Smets
  • Raf Wouters

In monetary policy strategies geared towards maintaining price stability, conditional and unconditional forecasts of inflation and output play an important role. In this article we illustrate how modern sticky-price dynamic stochastic general equilibrium (DSGE) models, estimated using Bayesian techniques, can become an additional useful tool in the forecasting kit of central banks. First, we show that the forecasting performance of such models compares well with a-theoretical vector autoregressions. Moreover, we illustrate how the posterior distribution of the model can be used to calculate the complete distribution of the forecast, as well as various inflation risk measures that have been proposed in the literature. Finally, the structural nature of the model allows computing forecasts conditional on a policy path. It also allows examination of the structural sources of the forecast errors and their implications for monetary policy. Using those tools, we analyse macroeconomic developments in the euro area since the start of EMU. Copyright Blackwell Publishing Ltd 2004.

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Article provided by Wiley Blackwell in its journal Journal of Common Market Studies.

Volume (Year): 42 (2004)
Issue (Month): 4 (November)
Pages: 841-867

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Handle: RePEc:bla:jcmkts:v:42:y:2004:i:4:p:841-867
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  1. Galí, Jordi & Gertler, Mark & López-Salido, J David, 2001. "European Inflation Dynamics," CEPR Discussion Papers 2684, C.E.P.R. Discussion Papers.
  2. Eric M. Leeper & Tao Zha, 2002. "Modest policy interventions," FRB Atlanta Working Paper No. 2002-19, Federal Reserve Bank of Atlanta.
  3. Peersman, Gert, 2003. "What Caused the Early Millennium Slowdown? Evidence Based on Vector Autoregressions," CEPR Discussion Papers 4087, C.E.P.R. Discussion Papers.
  4. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  5. Cogley, Timothy W. & Morozov, Sergei & Sargent, Thomas J., 2003. "Bayesian fan charts for UK inflation: Forecasting and sources of uncertainty in an evolving monetary system," CFS Working Paper Series 2003/44, Center for Financial Studies (CFS).
  6. Kilian, Lutz & Manganelli, Simone, 2003. "The central bank as a risk manager: quantifying and forecasting inflation risks," Working Paper Series 0226, European Central Bank.
  7. Fagan, Gabriel & Henry, Jérôme & Mestre, Ricardo, 2001. "An area-wide model (AWM) for the euro area," Working Paper Series 0042, European Central Bank.
  8. William A. Brock & Steven N. Durlauf & Kenneth D. West, 2003. "Policy Evaluation in Uncertain Economic Environments," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 235-322.
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