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Applied Economic Forecasting
using Time Series Methods
Applied Economic Forecasting using
Time Series Methods

Eric Ghysels
University of North Carolina, Chapel Hill, United States

Massimiliano Marcellino
Bocconi University, Milan, Italy

1
3
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You must not circulate this work in any other form

and you must impose this same condition on any acquirer.

Library of Congress Cataloging-in-Publication Data

Names: Ghysels, Eric, 1956- author. | Marcellino, Massimiliano, author.
Title: Applied economic forecasting using time series methods / Eric Ghysels
and Massimiliano Marcellino.
Description: New York, NY : Oxford University Press, [2018]
Identifiers: LCCN 2017046487 | ISBN 9780190622015 (hardcover : alk. paper) |
ISBN 9780190622039 (epub)
Subjects: LCSH: Economic forecasting–Mathematical models. | Economic
forecasting–Statistical methods.
Classification: LCC HB3730 .G459 2018 | DDC 330.01/51955–dc23 LC record
available at https://lccn.loc.gov/2017046487

9 8 7 6 5 4 3 2 1
Printed by Sheridan Books, Inc., United States of America
Contents

Preface xv

Part I Forecasting with the Linear Regression Model

1 The Baseline Linear Regression Model 3

1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 The basic specification . . . . . . . . . . . . . . . . . . . . . . 4
1.3 Parameter estimation . . . . . . . . . . . . . . . . . . . . . . 6
1.4 Measures of model fit . . . . . . . . . . . . . . . . . . . . . . 8
1.5 Constructing point forecasts . . . . . . . . . . . . . . . . . . . 10
1.6 Interval and density forecasts . . . . . . . . . . . . . . . . . . 13
1.7 Parameter testing . . . . . . . . . . . . . . . . . . . . . . . . 15
1.8 Variable selection . . . . . . . . . . . . . . . . . . . . . . . . . 18
1.9 Automated variable selection procedures . . . . . . . . . . . . 21
1.9.1 Forward selection (FWD) . . . . . . . . . . . . . . . . 22
1.9.2 Least angle regressions (LARS) . . . . . . . . . . . . . 22
1.9.3 LASSO and elastic net estimator (NET) . . . . . . . . 23
1.10 Multicollinearity . . . . . . . . . . . . . . . . . . . . . . . . . 24
1.11 Example using simulated data . . . . . . . . . . . . . . . . . 26
1.11.1 Data simulation procedure . . . . . . . . . . . . . . . . 26
1.12 Empirical examples . . . . . . . . . . . . . . . . . . . . . . . 32
1.12.1 Forecasting Euro area GDP growth . . . . . . . . . . . 32
1.12.2 Forecasting US GDP growth . . . . . . . . . . . . . . . 43
1.13 A hint of dynamics . . . . . . . . . . . . . . . . . . . . . . . . 47
1.13.1 Revisiting GDP forecasting . . . . . . . . . . . . . . . 48

v
vi CONTENTS

1.13.2 Forecasting default risk . . . . . . . . . . . . . . . . . . 49

1.14 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 55

2 Model Mis-Specification 57
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
2.2 Heteroskedastic and correlated errors . . . . . . . . . . . . . . 57
2.2.1 The Generalized Least Squares (GLS) estimator and
the feasible GLS estimator . . . . . . . . . . . . . . . . 60
2.3 HAC estimators . . . . . . . . . . . . . . . . . . . . . . . . . 64
2.4 Some tests for homoskedasticity and no correlation . . . . . . 66
2.5 Parameter instability . . . . . . . . . . . . . . . . . . . . . . . 69
2.5.1 The effects of parameter changes . . . . . . . . . . . . 70
2.5.2 Simple tests for parameter changes . . . . . . . . . . . 71
2.5.3 Recursive methods . . . . . . . . . . . . . . . . . . . . 74
2.5.4 Dummy variables . . . . . . . . . . . . . . . . . . . . . 76
2.5.5 Multiple breaks . . . . . . . . . . . . . . . . . . . . . . 78
2.6 Measurement error and real-time data . . . . . . . . . . . . . 80
2.7 Instrumental variables . . . . . . . . . . . . . . . . . . . . . . 82
2.8 Examples using simulated data . . . . . . . . . . . . . . . . . 84
2.9 Empirical examples . . . . . . . . . . . . . . . . . . . . . . . 94
2.9.1 Forecasting Euro area GDP growth . . . . . . . . . . . 94
2.9.2 Forecasting US GDP growth . . . . . . . . . . . . . . . 107
2.9.3 Default risk . . . . . . . . . . . . . . . . . . . . . . . . 114
2.10 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 118

3 The Dynamic Linear Regression Model 119

3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
3.2 Types of dynamic linear regression
models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
3.3 Estimation and testing . . . . . . . . . . . . . . . . . . . . . . 125
3.4 Model specification . . . . . . . . . . . . . . . . . . . . . . . . 126
3.5 Forecasting with dynamic models . . . . . . . . . . . . . . . . 128
3.6 Examples with simulated data . . . . . . . . . . . . . . . . . 130
3.7 Empirical examples . . . . . . . . . . . . . . . . . . . . . . . 132
3.7.1 Forecasting Euro area GDP growth . . . . . . . . . . . 133
3.7.2 Forecasting US GDP growth . . . . . . . . . . . . . . . 138
CONTENTS vii

3.7.3 Default risk . . . . . . . . . . . . . . . . . . . . . . . . 142

3.8 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 142

4 Forecast Evaluation and Combination 145

4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
4.2 Unbiasedness and efficiency . . . . . . . . . . . . . . . . . . . 146
4.3 Evaluation of fixed event forecasts . . . . . . . . . . . . . . . 149
4.4 Tests of predictive accuracy . . . . . . . . . . . . . . . . . . . 150
4.5 Forecast comparison tests . . . . . . . . . . . . . . . . . . . . 152
4.6 The combination of forecasts . . . . . . . . . . . . . . . . . . 154
4.7 Forecast encompassing . . . . . . . . . . . . . . . . . . . . . . 156
4.8 Evaluation and combination of density forecasts . . . . . . . . 157
4.8.1 Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . 158
4.8.2 Comparison . . . . . . . . . . . . . . . . . . . . . . . . 159
4.8.3 Combination . . . . . . . . . . . . . . . . . . . . . . . 159
4.9 Examples using simulated data . . . . . . . . . . . . . . . . . 160
4.10 Empirical examples . . . . . . . . . . . . . . . . . . . . . . . 164
4.10.1 Forecasting Euro area GDP growth . . . . . . . . . . . 164
4.10.2 Forecasting US GDP growth . . . . . . . . . . . . . . . 167
4.10.3 Default risk . . . . . . . . . . . . . . . . . . . . . . . . 169
4.11 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 170

Part II Forecasting with Time Series Models

5 Univariate Time Series Models 173

5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
5.2 Representation . . . . . . . . . . . . . . . . . . . . . . . . . . 174
5.2.1 Autoregressive processes . . . . . . . . . . . . . . . . . 176
5.2.2 Moving average processes . . . . . . . . . . . . . . . . 180
5.2.3 ARMA processes . . . . . . . . . . . . . . . . . . . . . 181
5.2.4 Integrated processes . . . . . . . . . . . . . . . . . . . 183
5.2.5 ARIMA processes . . . . . . . . . . . . . . . . . . . . . 184
5.3 Model specification . . . . . . . . . . . . . . . . . . . . . . . . 185
5.3.1 AC/PAC based specification . . . . . . . . . . . . . . . 185
5.3.2 Testing based specification . . . . . . . . . . . . . . . . 186
5.3.3 Testing for ARCH . . . . . . . . . . . . . . . . . . . . 187
viii CONTENTS

5.3.4 Specification with information criteria . . . . . . . . . 187

5.4 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
5.5 Unit root tests . . . . . . . . . . . . . . . . . . . . . . . . . . 190
5.6 Diagnostic checking . . . . . . . . . . . . . . . . . . . . . . . 195
5.7 Forecasting, known parameters . . . . . . . . . . . . . . . . . 196
5.7.1 General formula . . . . . . . . . . . . . . . . . . . . . . 196
5.7.2 Some examples . . . . . . . . . . . . . . . . . . . . . . 197
5.7.3 Some additional comments . . . . . . . . . . . . . . . . 201
5.8 Forecasting, estimated parameters . . . . . . . . . . . . . . . 202
5.9 Multi-steps (or direct) estimation . . . . . . . . . . . . . . . . 204
5.10 Permanent-transitory decomposition . . . . . . . . . . . . . . 207
5.10.1 The Beveridge Nelson decomposition . . . . . . . . . . 207
5.10.2 The Hodrick-Prescott filter . . . . . . . . . . . . . . . . 209
5.11 Exponential smoothing . . . . . . . . . . . . . . . . . . . . . 209
5.12 Seasonality . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
5.12.1 Deterministic seasonality . . . . . . . . . . . . . . . . . 212
5.12.2 Stochastic seasonality . . . . . . . . . . . . . . . . . . . 213
5.13 Examples with simulated data . . . . . . . . . . . . . . . . . 214
5.13.1 Stationary ARMA processes . . . . . . . . . . . . . . . 214
5.13.2 Estimation: Full sample analysis . . . . . . . . . . . . 218
5.13.3 Estimation: Subsample analysis . . . . . . . . . . . . . 220
5.13.4 Forecasting . . . . . . . . . . . . . . . . . . . . . . . . 227
5.14 Empirical examples . . . . . . . . . . . . . . . . . . . . . . . 228
5.14.1 Modeling and forecasting the US federal funds rate . . 228
5.14.2 Modeling and forecasting US inventories . . . . . . . . 240
5.15 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 251

6 VAR Models 253

6.1 Representation . . . . . . . . . . . . . . . . . . . . . . . . . . 254
6.2 Specification of the model . . . . . . . . . . . . . . . . . . . . 256
6.3 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
6.4 Diagnostic checks . . . . . . . . . . . . . . . . . . . . . . . . . 260
6.5 Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
6.6 Impulse response functions . . . . . . . . . . . . . . . . . . . 263
6.7 Forecast error variance decomposition . . . . . . . . . . . . . 268
6.8 Structural VARs with long-run restrictions . . . . . . . . 269
6.9 VAR models with simulated data . . . . . . . . . . . . . . . . 271
CONTENTS ix

6.10 Empirical examples . . . . . . . . . . . . . . . . . . . . . . . 282

6.10.1 GDP growth in the Euro area . . . . . . . . . . . . . . 282
6.10.2 Monetary transmission mechanism . . . . . . . . . . . 289
6.11 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 300

7 Error Correction Models 301

7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
7.2 Spurious regressions . . . . . . . . . . . . . . . . . . . . . . . 302
7.3 Cointegration and error correction models . . . . . . . . . . . 303
7.4 Engle and Granger cointegration test . . . . . . . . . . . . . . 305
7.5 Johansen cointegration test . . . . . . . . . . . . . . . . . . . 306
7.6 MA representations of cointegrated
processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
7.7 Forecasting in the presence of
cointegration . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
7.8 The effects of stochastic trends on
forecasts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
7.9 Example using simulated series . . . . . . . . . . . . . . . . . 313
7.10 Empirical examples . . . . . . . . . . . . . . . . . . . . . . . 323
7.10.1 Term structure of UK interest rates . . . . . . . . . . . 323
7.10.2 Composite coincident and leading indexes . . . . . . . 334
7.10.3 Predicting coincident and leading indices in the period
before the crisis . . . . . . . . . . . . . . . . . . . . . . 334
7.10.4 Predicting coincident and leading indices
during the financial crisis . . . . . . . . . . . . . . . . . 340
7.11 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 342

8 Bayesian VAR Models 345

8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
8.2 A primer on Bayesian econometrics . . . . . . . . . . . . . . . 346
8.2.1 Parameters as random variables . . . . . . . . . . . . . 347
8.2.2 From prior to posterior distribution . . . . . . . . . . . 347
8.2.3 An example: The posterior of the mean when the
variance is known . . . . . . . . . . . . . . . . . . . . . 348
8.2.4 The Bayesian linear regression model . . . . . . . . . . 350
8.3 Baseline Bayesian VAR case . . . . . . . . . . . . . . . . . . . 353
x CONTENTS

8.3.1 Baseline BVAR specification . . . . . . . . . . . . . . . 353

8.3.2 Prior parameterizations . . . . . . . . . . . . . . . . . 354
8.4 Forecasting with the BVAR . . . . . . . . . . . . . . . . . . . 356
8.4.1 The proper method . . . . . . . . . . . . . . . . . . . . 356
8.4.2 The pseudo-iterated approach . . . . . . . . . . . . . . 357
8.4.3 The direct forecasting approach . . . . . . . . . . . . . 358
8.5 Example with simulated data . . . . . . . . . . . . . . . . . . 359
8.6 Empirical examples . . . . . . . . . . . . . . . . . . . . . . . 361
8.6.1 GDP growth in the Euro area . . . . . . . . . . . . . . 361
8.6.2 Multi-country inflation rates . . . . . . . . . . . . . . . 362
8.7 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 364

Part III TAR, Markov Switching, and State Space

Models

9 TAR and STAR Models 369

9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
9.2 Specification . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
9.3 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
9.4 Testing for STAR and TAR . . . . . . . . . . . . . . . . . . . 374
9.5 Diagnostic tests . . . . . . . . . . . . . . . . . . . . . . . . . 376
9.6 Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
9.6.1 Point forecasts . . . . . . . . . . . . . . . . . . . . . . 376
9.6.2 Interval forecasts . . . . . . . . . . . . . . . . . . . . . 378
9.7 Artificial neural networks . . . . . . . . . . . . . . . . . . . . 379
9.8 Example: Simulated data . . . . . . . . . . . . . . . . . . . . 382
9.8.1 Testing for linearity versus non-linearity . . . . . . . . 382
9.8.2 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . 384
9.8.3 Forecasting . . . . . . . . . . . . . . . . . . . . . . . . 386
9.8.4 Two-steps ahead forecasting . . . . . . . . . . . . . . . 388
9.9 Example: Forecasting industrial
production growth . . . . . . . . . . . . . . . . . . . . . . . . 392
9.10 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 397

10 Markov Switching Models 399

10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399
CONTENTS xi

10.2 Markov chains . . . . . . . . . . . . . . . . . . . . . . . . . . 400

10.3 Mixture of i.i.d. distributions . . . . . . . . . . . . . . . . . . 403
10.4 Markov switching dynamic models . . . . . . . . . . . . . . . 406
10.5 Empirical example: Simulated data . . . . . . . . . . . . . . . 410
10.6 Empirical example: Industrial production . . . . . . . . . . . 413
10.7 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 417

11 State Space Models 419

11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419
11.2 Models in state space form . . . . . . . . . . . . . . . . . . . 420
11.2.1 An ARMA(2,2) model . . . . . . . . . . . . . . . . . . 421
11.2.2 A time-varying parameters (TVP) regression model . . 422
11.2.3 A model with stochastic volatility . . . . . . . . . . . . 423
11.2.4 A dynamic factor model . . . . . . . . . . . . . . . . . 424
11.2.5 Unobserved component models . . . . . . . . . . . . . 425
11.3 The Kalman filter . . . . . . . . . . . . . . . . . . . . . . . . 426
11.3.1 The key equations of the Kalman filter . . . . . . . . . 427
11.3.2 The iterative procedure . . . . . . . . . . . . . . . . . . 429
11.3.3 Some derivations and additional results . . . . . . . . . 430
11.4 Example with simulated data: The TVP regression model . . 432
11.5 Empirical examples . . . . . . . . . . . . . . . . . . . . . . . 440
11.5.1 Forecasting US GDP growth with a TVP model . . . . 440
11.5.2 Forecasting GDP growth with dynamic factor models . 444
11.6 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 449

Part IV Mixed Frequency, Large Datasets, and

Volatility

12 Models for Mixed-Frequency Data 453

12.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 453
12.2 Bridge equations . . . . . . . . . . . . . . . . . . . . . . . . . 455
12.3 MIDAS Regressions . . . . . . . . . . . . . . . . . . . . . . . . 459
12.3.1 The basic MIDAS regression model . . . . . . . . . . . 460
12.3.2 The AR-MIDAS and ADL-MIDAS models . . . . . . . 463
12.3.3 Slope or no slope? . . . . . . . . . . . . . . . . . . . . . 463
12.3.4 U-MIDAS and MIDAS with step functions . . . . . . 465
xii CONTENTS

12.3.5 Extensions of the MIDAS regression model . . . . . . . 466

12.4 Mixed-frequency VAR . . . . . . . . . . . . . . . . . . . . . . 470
12.4.1 Parameter-driven approach . . . . . . . . . . . . . . . . 471
12.4.2 Observation-driven approach . . . . . . . . . . . . . . . 474
12.5 Example: Nowcasting with simulated data . . . . . . . . . . . 476
12.5.1 The bridge equation approach . . . . . . . . . . . . . . 477
12.5.2 The MIDAS regression approach . . . . . . . . . . . . 480
12.6 Example: Nowcasting US GDP growth . . . . . . . . . . . . . 482
12.6.1 Predicting the worst trough of the crisis . . . . . . . . 483
12.6.2 Predicting mild positive and negative growth rates . . 493
12.6.3 Predicting GDP growth rates, 2007-2012 . . . . . . . . 496
12.7 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 501

13 Models for Large Datasets 503

13.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503
13.2 Factor models . . . . . . . . . . . . . . . . . . . . . . . . . . 504
13.3 The three pass regression filter . . . . . . . . . . . . . . . . . . 509
13.4 Large unbalanced datasets . . . . . . . . . . . . . . . . . . . . 512
13.4.1 Mixed-frequency factor models . . . . . . . . . . . . . . 512
13.4.2 Mixed-frequency three pass regression filter . . . . . . . 516
13.4.3 Missing observations and ragged edges . . . . . . . . . 519
13.5 Example with simulated data . . . . . . . . . . . . . . . . . . 520
13.6 Empirical example: Forecasting GDP growth . . . . . . . . . 521
13.7 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 527

14 Forecasting Volatility 531

14.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
14.2 ARCH-type models . . . . . . . . . . . . . . . . . . . . . . . 532
14.2.1 Model specifications . . . . . . . . . . . . . . . . . . . 533
14.2.2 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . 537
14.3 MIDAS regressions and volatility forecasting . . . . . . . . . 539
14.3.1 Realized volatility . . . . . . . . . . . . . . . . . . . . . 540
14.3.2 Realized volatility and MIDAS regressions . . . . . . . 541
14.3.3 HAR models . . . . . . . . . . . . . . . . . . . . . . . . 541
14.3.4 Direct versus iterated volatility forecasting . . . . . . . 542
14.3.5 Variations on the theme of MIDAS regressions . . . . . 544
CONTENTS xiii

14.4 GARCH models again . . . . . . . . . . . . . . . . . . . . . . 545

14.5 Volatility forecasting evaluation . . . . . . . . . . . . . . . . . 546
14.6 Forecasting S&P 500 index volatility . . . . . . . . . . . . . . 548
14.6.1 ARCH-type models . . . . . . . . . . . . . . . . . . . 549
14.6.2 Realized volatility . . . . . . . . . . . . . . . . . . . . 551
14.7 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . 555

Bibliography 559

Subject Index 587

Author Index 592

Preface

Economic forecasting is a key ingredient of decision making both in the pub-

lic and in the private sector. Governments and central banks, consumers and
firms, banks and financial institutions base many of their decisions on future
expected economic conditions or on the predictions of specific indicators of
interest such as income growth, inflation, unemployment, interest rates, ex-
change rates, earnings, wages, oil prices, and so on. Unfortunately, economic
outcomes are the realization of a vast, complex, dynamic and stochastic
system, which makes forecasting very difficult and forecast errors unavoid-
able. However, forecast precision and reliability can be enhanced by the use
of proper econometric models and methods, like those we present in this
book.
We wish to satisfy an audience including both undergraduate and gradu-
ate students willing to learn basic and advanced forecasting techniques, and
researchers in public and private institutions interested in applied economic
forecasting. For this reason, the book is divided into four parts. In Part I, the
first chapter provides a brief review of basic regression analysis, followed by
two chapters dealing with specific regression topics relevant for forecasting,
such as model mis-specification, including structural breaks, and dynamic
models and their predictive properties. The fourth chapter, on the topic
of forecast evaluation and combination, is the first exclusively dedicated to
forecasting. The material in Part I could be used in the senior year of an
undergraduate program for students who have a strong interest in applied
econometrics, or as an introduction to economic forecasting for graduate stu-
dents and researchers from other disciplines.
Part II of the book is devoted to time series models, in particular univari-
ate autoregressive integrated moving average (ARIMA) models and vector
autoregressive (VAR) models. Specifically, Chapter 5 deals with ARIMA
models, Chapter 6 with VAR models, Chapter 7 with cointegration and er-

xv
xvi PREFACE

ror correction (ECM) models, and Chapter 8 with Bayesian methods for
VAR analysis. The material progressively becomes better suited for master
level and/or PhD level classes, in particular the chapters on cointegration
and Bayesian VARs. Models considered in Part II are also common tools for
practical forecasting in public and private institutions.
Parts III and IV of the book contain a collection of special topics chapters.
Each chapter is self-contained, and therefore an instructor or researcher can
pick and choose the topics she or he wants to cover. Part III deals mainly
with modeling parameter time-variation. Specifically, Chapter 9 presents
Threshold and Smooth Transition Autoregressive (TAR and STAR) models,
Chapter 10 Markov switching regime models, and Chapter 11 state space
models and the Kalman filter, introducing, for example, models with random
coefficients and dynamic factor models.
Part IV deals with mixed frequency data models and their use for now-
casting in Chapter 12, forecasting using large datasets in Chapter 13 and,
finally, volatility models in Chapter 14.
Each chapter starts with a review of the main theoretical results to pre-
pare the reader for the various applications. Examples involving simulated
data follow, to make the reader familiar with application using at first styl-
ized settings where one knows the true data generating process and one
learns how to apply the techniques introduced in each chapter. From our
own teaching experience we find this to be extremely useful as it creates
familiarity with each of the topics in a controlled environment. The simu-
lated examples are followed by real data applications - focusing on macroe-
conomic and financial topics. Some of the examples run across different
chapters, particularly in the early part of the book. All data are public
domain and cover Euro area, UK, and US examples, including forecasting
US GDP growth, default risk, inventories, effective federal funds rates, com-
posite index of leading indicators, industrial production, Euro area GDP
growth, UK term structure of interest rates, to mention the most prominent
examples.
The book is mostly software neutral. However, for almost all the simu-
lated and empirical examples we provide companion EViews R and R code.
The former is mostly - but not exclusively - a menu driven licensed software
package whereas the latter is an open source programming language and soft-
ware environment for statistical computing and graphics supported by the
PREFACE xvii

R Foundation for Statistical Computing.1 . We provide code and data for all
the simulated and empirical examples in the book on the web.2 Moreover, all
the tables and figures appearing in the book were produced using EViews R .
As the title suggests, this book is an applied time series forecasting book.
Hence, we do not have the pretense to provide the full theoretical founda-
tions for the forecasting methods we present. Indeed, there are already a
number of books with thorough coverage of theory. The most recent exam-
ple is the excellent book by Elliott and Timmermann (2016) which provides
an in-depth analysis of the statistical theory underlying predictive models,
covering a variety of alternative forecasting methods in both classical and
Bayesian contexts, as well as techniques for forecast evaluation, comparison,
and combination. Equally useful and complimentary are the many standard
econometrics textbooks such as Hendry (1995), Judge, Hill, Griffiths, Lütke-
pohl, and Lee (1988), Stock and Watson (2009), Wooldridge (2012), and
the many graduate time series textbooks such as Box and Jenkins (1976),
Clements and Hendry (1998), Diebold (2008), Hamilton (1994), or Lütkepohl
(2007), among others.
We should also highlight that this book is an applied time series forecast-
ing book. As such, we will not discuss forecasting using economic theory-
based structural models, such as Dynamic Stochastic General Equilibrium
(DSGE) models, see, e.g., Del Negro and Schorfheide (2013) for an exhaus-
tive overview and references. Typically, these structural models are better
suited for medium- and long-horizon forecasting, and for policy simulations,
while time series methods work better for nowcasting and short-term fore-
casting (say, up to one-year ahead).
This book would not have been completed without the invaluable and
skillful help of a number of our current and former TAs and RAs. Special
thanks go to Cristina Angelico, Francesco Corsello, Francesco Giovanardi,
Novella Maugeri, and Nazire Özkan who helped with all the simulation and
empirical examples throughout the entire book, as well as Hanwei Liu who
wrote the R codes. Their contributions to the book were invaluable. We
would also like to thank many cohorts of undergraduate, master, and PhD
1
Please visit the web page http://www.eviews.com for further information on EViews R
and R programming language Wikipedia web page https://en.wikipedia.org/wiki/R
(programming language).
2
Please visit our respective webpages www.unc.edu/∼eghysels or www.igier.unibocconi.
it/marcellino to download the code and data.
xviii PREFACE

students who took courses based on the materials covered in the book at
Bocconi University and at the University of North Carolina, Chapel Hill and
the Kenan-Flagler Business School.
We are also grateful to a number of coauthors of papers on the topics
covered in the book. In particular, Eric Ghysels would like to thank Lucia
Alessi, Elena Andreou, Jennie Bai, Fabio Canova, Xilong Chen, Riccardo
Colacito, Robert Engle, Claudia Foroni, Lars Forsberg, Patrick Gagliardini,
René Garcia, Clive Granger, Andrew Harvey, Jonathan Hill, Casidhe Horan,
Lynda Khalaf, Andros Kourtellos, Virmantas Kvedaras, Emanuel Moench,
Kaiji Motegi, Denise Osborn, Alberto Plazzi, Eric Renault, Mirco Rubin,
Antonio Rubia, Pedro Santa-Clara, Pierre Siklos, Arthur Sinko, Bumjean
Sohn, Ross Valkanov, Cosmé Vodounou, Fangfang Wang, Jonathan Wright,
and Vaidotas Zemlys (and Massimiliano of course!). Massimiliano Marcellino
would like to thank Knut-Are Aastveit, Angela Abbate, Elena Angelini, Mike
Artis, Anindya Banerjee, Guenter Beck, Stelios Bekiros, Ralf Burggemann,
Andrea Carriero, Roberto Casarin, Todd Clark, Francesco Corielli, Sandra
Eickmeier, Carlo Favero, Laurent Ferrara, Claudia Foroni, Giampiero Gallo,
Ana Galvão, Pierre Guérin, Jerome Henry, Christian Hepenstrick, Kristin
Hubrich, Oscar Jorda, George Kapetanios, Malte Knüppel, Hans-Martin
Krolzig, Danilo Leiva-Leon, Wolfgang Lemke, Helmut Lütkepohl, Igor Mas-
ten, Gian Luigi Mazzi, Grayham Mizon, Matteo Mogliani, Alberto Musso,
Chiara Osbat, Fotis Papailias, Mario Porqueddu, Esteban Prieto, Tommaso
Proietti, Francesco Ravazzolo, Christian Schumacher, Dalibor Stevanovic,
Jim Stock, Fabrizio Venditti, and Mark Watson (and Eric of course!).
Several colleagues provided useful comments on the book, in particular
Frank Diebold, Helmut Lütkepohl, Serena Ng, Simon Price, Frank Schorfheide,
and Allan Timmermann. Of course, we remain responsible for any remaining
mistakes or omissions.
Finally, we would like to thank our families for their continuous support
and understanding. We forecast a quieter and more relaxed “Life after the
Book,” but as all forecasters, we could be proven wrong.

Eric Ghysels, Chapel Hill, United States

Massimiliano Marcellino, Milan, Italy
 Part I

Forecasting with the Linear

Regression Model
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