Designing Gaps as Early Warning Indicators: Accuracy, Predictive Power, and Robustness
23 Pages Posted: 6 Feb 2019
Date Written: January 2019
Credit gaps, or deviations of credit from its long-run trend, are commonly used in early warning indicators of financial crises. When the gap breaches a certain critical threshold, it triggers a signal. Previous studies set the threshold to balance the trade-off between accuracy and predictive power. We show how this trade-off improves significantly by varying the smoothing parameter inherent in different statistical approaches for estimating gaps. In addition, we compare the performance of alternative gap estimates for advanced and emerging market economies separately, while taking into account the robustness of these gaps in real-time to the arrival of new information.
Keywords: Credit, Credit Gap, Optimization, Predictive Power, Robustness, Trend-Cycle Decomposition
JEL Classification: C22, E39, G28
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