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Diffusion Indexes

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  • James H. Stock
  • Mark W. Watson

Abstract

This paper considers forecasting a single time series using more predictors than there are time series observations. The approach is to construct a relatively few indexes, akin to diffusion indexes, which are weighted averages of the predictors, using an approximate dynamic factor model. Estimation is discussed for balanced and unbalanced panels. The estimated dynamic factors are (uniformly) consistent, even in the presence of time varying parameters and/or data contamination, and forecasts based on the estimated factors are efficient. In an application to forecasting U.S. inflation and industrial production using 224 monthly time series, these forecasts outperform various state-of-the-art benchmark models.

Suggested Citation

  • James H. Stock & Mark W. Watson, 1998. "Diffusion Indexes," NBER Working Papers 6702, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:6702
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    References listed on IDEAS

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    1. Forni, Mario & Reichlin, Lucrezia, 1996. "Dynamic Common Factors in Large Cross-Sections," Empirical Economics, Springer, vol. 21(1), pages 27-42.
    2. Danny Quah & Thomas J. Sargent, 1993. "A Dynamic Index Model for Large Cross Sections," NBER Chapters,in: Business Cycles, Indicators and Forecasting, pages 285-310 National Bureau of Economic Research, Inc.
    3. Robert J. Gordon, 1997. "The Time-Varying NAIRU and Its Implications for Economic Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 11-32, Winter.
    4. Snower,Dennis J. & Dehesa,Guillermo de la (ed.), 1997. "Unemployment Policy," Cambridge Books, Cambridge University Press, number 9780521599214.
    5. Connor, Gregory & Korajczyk, Robert A, 1993. " A Test for the Number of Factors in an Approximate Factor Model," Journal of Finance, American Finance Association, vol. 48(4), pages 1263-1291, September.
    6. Geweke, John & Zhou, Guofu, 1996. "Measuring the Pricing Error of the Arbitrage Pricing Theory," Review of Financial Studies, Society for Financial Studies, vol. 9(2), pages 557-587.
    7. Forni, Mario & Reichlin, Lucrezia, 1997. "National Policies and Local Economies: Europe and the United States," CEPR Discussion Papers 1632, C.E.P.R. Discussion Papers.
    8. Douglas Staiger & James H. Stock & Mark W. Watson, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter.
    9. Schneeweiss, H. & Mathes, H., 1995. "Factor Analysis and Principal Components," Journal of Multivariate Analysis, Elsevier, vol. 55(1), pages 105-124, October.
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    12. Sargent, Thomas J, 1989. "Two Models of Measurements and the Investment Accelerator," Journal of Political Economy, University of Chicago Press, vol. 97(2), pages 251-287, April.
    13. Forni, Mario & Reichlin, Lucrezia, 1995. "Let's Get Real: A Dynamic Factor Analytical Approach to Disaggregated Business Cycle," CEPR Discussion Papers 1244, C.E.P.R. Discussion Papers.
    14. Bekker, Paul & Dobbelstein, Pascal & Wansbeek, Tom, 1996. "The APT Model as Reduced-Rank Regression," Journal of Business & Economic Statistics, American Statistical Association, vol. 14(2), pages 199-202, April.
    15. Jeffrey C. Fuhrer, 1995. "The Phillips curve is alive and well," New England Economic Review, Federal Reserve Bank of Boston, issue Mar, pages 41-56.
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    More about this item

    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
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications

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