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Improved Construction of diffusion indexes for macroeconomic forecasting

Author

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  • Heij, C.
  • van Dijk, D.J.C.
  • Groenen, P.J.F.

Abstract

This article proposes a modified method for the construction of diffusion indexes in macroeconomic forecasting using principal component regres- sion. The method aims to maximize the amount of variance of the origi- nal predictor variables retained by the diffusion indexes, by matching the data windows used for constructing the principal components and for es- timating the diffusion index models. The method is applied to construct forecasts of eight monthly US macroeconomic time series, using the data set of Stock and Watson (2002a). The results show that the proposed method leads, on average, to simpler models with smaller forecast errors than previously used methods.

Suggested Citation

  • Heij, C. & van Dijk, D.J.C. & Groenen, P.J.F., 2006. "Improved Construction of diffusion indexes for macroeconomic forecasting," Econometric Institute Research Papers EI 2006-03-REV, Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute.
    • Handle: RePEc:ems:eureir:7581
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    References listed on IDEAS

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    1. Boivin, Jean & Ng, Serena, 2006. "Are more data always better for factor analysis?," Journal of Econometrics, Elsevier, vol. 132(1), pages 169-194, May.
    2. Diebold, Francis X & Mariano, Roberto S, 2002. "Comparing Predictive Accuracy," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 134-144, January.
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    More about this item

    Keywords

    factor construction; forecasting; principal components;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • E17 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Forecasting and Simulation: Models and Applications

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