Estimating and Accounting for the Output Gap with Large Bayesian Vector Autoregressions

Journal of Applied Econometrics, Forthcoming

35 Pages Posted: 12 Aug 2019

See all articles by James Morley

James Morley

University of Sydney

Benjamin Wong

Monash University - Department of Econometrics & Business Statistics

Multiple version iconThere are 2 versions of this paper

Date Written: July 16, 2019

Abstract

We consider how to estimate the trend and cycle of a time series, such as real GDP, given a large information set. Our approach makes use of the Beveridge-Nelson decomposition based on a vector autoregression, but with two practical considerations. First, we show how to determine which conditioning variables span the relevant information by directly accounting for the Beveridge-Nelson trend and cycle in terms of contributions from different forecast errors. Second, we employ Bayesian shrinkage to avoid overfitting in finite samples when estimating models that are large enough to include many possible sources of information. An empirical application with up to 138 variables covering various aspects of the U.S. economy reveals that the unemployment rate, inflation, and, to a lesser extent, housing starts, aggregate consumption, stock prices, real money balances, and the federal funds rate contain relevant information beyond that in output growth for estimating the output gap, with estimates largely robust to substituting some of these variables or incorporating additional variables.

Keywords: Beveridge-Nelson decomposition, output gap, Bayesian estimation, multivariate information

JEL Classification: C18, E17, E32

Suggested Citation

Morley, James and Wong, Benjamin, Estimating and Accounting for the Output Gap with Large Bayesian Vector Autoregressions (July 16, 2019). Journal of Applied Econometrics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3434177

James Morley

University of Sydney ( email )

Rm 370 Merewether (H04)
Sydney, NSW 2006 2008
Australia

HOME PAGE: http://https://sites.google.com/site/jamescmorley/

Benjamin Wong (Contact Author)

Monash University - Department of Econometrics & Business Statistics ( email )

Wellington Road
Clayton, Victoria 3168
Australia

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