The Role of Financial Variables in Predicting Economic Activity in the Euro Area

36 Pages Posted: 10 Nov 2009

See all articles by Raphael A. Espinoza

Raphael A. Espinoza

International Monetary Fund (IMF)

Fabio Fornari

European Central Bank (ECB)

Marco J. Lombardi

Bank for International Settlements (BIS) - Monetary and Economic Department

Date Written: September 2009

Abstract

The U.S. business cycle typically leads the European cycle by a few quarters and this can be used to forecast euro area GDP. We investigate whether financial variables carry additional information. We use vector autoregressions (VARs) which include the U.S. and the euro area GDPs as a minimal set of variables as well as growth in the Rest of the World (an aggregation of seven small countries) and selected combinations of financial variables. Impulse responses (in-sample) show that shocks to financial variables influence real activity. However, according to out-of-sample forecast exercises using the Root Mean Square Error (RMSE) metric, this macro-financial linkage would be weak: financial indicators do not improve short and medium term forecasts of real activity in the euro area, even when their timely availability, relative to GDP, is exploited. This result is partly due to the 'average' nature of the RMSE metric: when forecasting ability is assessed as if in real time (conditionally on the information available at the time of the forecast), we find that models using financial variables would have been preferred, ex ante, in several episodes, in particular between 1999 and 2002. This result suggests that one should not discard, on the basis of RMSE statistics, the use of predictive models that include financial variables if there is a theoretical prior that a financial shock is affecting growth.

Keywords: Asset prices, Business cycles, Cross country analysis, Economic forecasting, Economic growth, Economic models, Euro Area, Financial crisis, Financial sector, Global Financial Crisis 2008-2009, Stock markets

Suggested Citation

Espinoza, Raphael A. and Fornari, Fabio and Lombardi, Marco Jacopo, The Role of Financial Variables in Predicting Economic Activity in the Euro Area (September 2009). IMF Working Paper No. 09/241, Available at SSRN: https://ssrn.com/abstract=1503203

Raphael A. Espinoza (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

HOME PAGE: http://oxford.academia.edu/RaphaelEspinoza

Fabio Fornari

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Marco Jacopo Lombardi

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland
+41612809492 (Phone)

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