Forecasting with a forward-looking DGE model: combining long-run views of financial markets with macro forecasting

Abstract

To develop forecasting procedures with a forward-looking dynamic general equilibrium model, we built a small New-Keynesian model and calibrated it to euro area data. It was essential in this context that we allowed for long-run growth in GDP. We brought additional asset price equations based on the expecta-tions hypothesis and the Gordon growth model, into the standard open economy model, in order to extract information on private sector long-run expectations on fundamentals, and to combine that information into the macro economic forecast. We propose a method of transforming the model in forecasting use in such a way, as to match, in an economically meaningful way, the short-term forecast levels, especially of the model's jump-variables, to the parameters affecting the long-run trends of the key macroeconomic variables. More specifically, in the model we have used for illustrative purposes, we pinned down the long-run inflation expectations and domestic and foreign potential growth-rates using the model's steady state solution in combination with, by assumption, forward looking information in up-to-date financial market data. Consequently, our proposed solution preserves consistency with market expectations and results, as a favourable by-product, in forecast paths with no initial, first forecast period jumps. Further-more, no ad hoc re-calibration is called for in the proposed forecasting procedures, which clearly is an advantage from point of view of transparency in communication.forecasting; New Keynesian model; DSGE model; rational expectations; open economy