A New Index of Financial Conditions
34 Pages Posted: 6 Jan 2014
Date Written: December 1, 2013
We use factor augmented vector autoregressive models with time-varying coefficients and stochastic volatility, to construct a financial conditions index that can accurately track expectations about growth in US GDP and unemployment. Time-variation in the model's parameters allows for the weights attached to each financial variable in the index to evolve over time. Furthermore, we develop methods for dynamic model averaging or selection which allow the financial variables entering into the FCI to change over time. We discuss why such extensions of the existing literature are important and show them to be so in an empirical application involving a wide range of financial variables.
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