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A famous economist once remarked, “We have two classes of forecasters: Those

who don’t know and those who don’t know that they don’t know.” Experienced
economists know that economic forecasting is full of uncertainty.

Predicting trends in macroeconomic conditions and their impact on costs or


demand for company goods and services is one of the most difficult responsibilities
facing management. Predicting the effects of changes in the competitive
micro-economic environment can also be daunting. However, forecasting is a
necessary task because, for better or worse, all decisions made on the basis of
future expectations.

FORECASTING APPLICATIONS

Managers must make informed forecasts when it comes to deciding on new


product introductions, pricing products, or making hiring decisions.

 Macroeconomic forecasting involves predicting aggregate measures of


economic activity at the international, national, regional or state levels.
Predictions of gross domestic product (GDP), unemployment, and interest
rates by “blue chip” business economists capture the attention of national
media, business, government, and the general public on a daily basis. GDP is
the value at final point of sale of all goods and services produced in the
domestic economy during a given period by both domestic and foreign-owned
enterprises. Gross national (GNP) is the value at final point of sale of all
goods and services produced by domestic firms. GNP does not reflect domestic
production by foreign-owned firms, GDP does.

Macroeconomic forecasts commonly reported in the press include predictions


of consumer spending, business investment, home building, exports, imports,
federal purchase, state and local government spending, and so on.
Macroeconomic predictions are important because they are used by business
and individuals to make day-to-day operating decisions and long-term
planning decisions. If interest rates are projected to rise, homeowners may
rush to refinance fixed-rate mortgages, although businesses float new bond
and stock offerings to refinance existing debt or take advantage of investment
opportunities. When such predictions are accurate, significant cost savings or
revenue gains become possible.

The accuracy of any forecast is subject to the influence of controllable and


uncontrollable factors. In macroeconomic forecasting, uncontrollable factors
seem large.
Example is interest rate forecasting. The demand for credit and short-term
interest rates rise if businesses seek to build inventories or expand plant and
equipment, or if consumers wish to increase installment credit. The supply of
credit rises and short-term interest rates falls if the Federal Reserve System
acts to increase the money supply, or if consumers cut back on spending to
increase savings. Interest rate forecasting is made difficult by the fact that
business decisions to build inventories, for example, are largely based on the
expected pace of overall economic activity- which itself depends on
interest-rate expectations. The macroeconomic environment is interrelated in
ways that are unstable and cannot be easily predicted.

 Micro-economic Applications involves the prediction of economic data at the


industry, firm, plant, or product levels. Unlike predictions of GDP growth,
which are widely followed in the press, the general public often ignores micro
economic forecast of scrap prices for aluminum, the demand for new cars, or
production costs for Crest toothpaste. It is unlikely that the CBS Evening
News will never be interrupted to discuss an upward trend in used-car prices,
even though these data are an excellent predictor of new-car demand. When
used-car prices surge, new-car demand typically drops. The fact that used-car
prices and new-car demand are closely related is not surprising given the
strong substitute-good relation that exists between used cars and new cars.

Trained and experienced analyst often find it easier to accurately forecast


micro economic trends, such as the demand for new cars, than macroeconomic
trends, such as GDP growth. This is because micro-economic forecasts
abstract from the multitude of interrelationships that together determine the
macro economy.

FORECAST TECHNIQUES

Accurate forecasts require pertinent data that are current, complete, and free
from error and bias. One of the most vexing (bothersome) data quality problems
encountered in forecasting is the obstacle presented by government-supplied
data that are often tardy and inaccurate.

To overcome forecasting problems caused by error and bias, a variety of


forecast methods can be employed. Some forecast techniques are basically
quantitative; others are largely qualitative. The most commonly forecasting
techniques can be divided into the following broad categories:

1. Qualitative analyses
2. Trend analysis and projection

3. Exponential smoothing

4. Econometric methods

The best forecast method for any particular task depends on the nature of the
forecasting problem. The following should be considered:

 The distance into the future that one must forecast

 The lead time available for making decisions

 The level of accuracy required

 The quality of data available for analysis

 The stochastic or deterministic nature of forecast relations

 The cost and benefits associated with the forecasting problem

The techniques that are well-suited for short-term projections are:

 Trend analysis

 Market experiments

 Consumer Surveys

 Leading indicator approach

Forecasting with complex econometric models and systems of simultaneous


equations has proven somewhat more useful for long-run forecasting.

Typically, the greater the level of sophistication, the greater is the cost. If the
required level of accuracy is low, less sophisticated methods can provide adequate
results at minimal cost.

QUALITATIVE ANALYSIS

Qualitative Analysis is an intuitive approach to forecasting that can be useful


if it allows for the systematic collection of data from unbiased and informed
opinion.
1. Expert Opinion

 PERSONAL INSIGHT - the most basic form of qualitative analysis


forecasting is , in which an informed individual uses personal or
company experience as a basis for developing future expectations.
Although this approach is subjective(personal), the reasoned
judgment of informed individuals often provides valuable insight.

 PANEL CONSENSUS - when the informed opinion of several


individuals is relied on. This method assumes that several experts
can arrive at forecasts that are superior to those that individuals
generate. Direct interaction among experts can help insure that
resulting forecasts embody (to be part of) all available objective and
subjective information. Though it is from the collective wisdom of
consulted experts, it can unfavorably affected by the forceful
personality of one or a few key individuals.

 DELPHI METHOD - members of a panel of experts individually


receive a series of questions relating to the underlying forecasting
problem. Responses are analyzed by an independent party, who then
tries to elicit (to draw out) a consensus opinion (general agreement)
by providing feedback to panel members in a manner that prevents
direct identification of individual positions. This method helps limit
the steamroller or bandwagon problems of the basic panel consensus
approach.

2. Survey Techniques

Survey Techniques generally use interviews or mailed questionnaires


that ask firms, government agencies, and individuals about their future
plans. Businesses plan and budget virtually all their expenditures in
advance of actual purchase or production decisions. Surveys asking about
capital budgets, sales budgets, and operating budgets can be useful
forecast information. Individuals consumers routinely plan expenditures
for such major items that surveys of consumer intentions often accurately
predict future spending on consumer goods.

Although surveys sometimes serve as an alternative to quantitative


forecasting techniques, they frequently supplement rather than replace
quantitative analysis. Their value stems from two influences:

 A hard-to quantify psychological element is inherent in most


economic behavior; surveys and other qualitative methods
are especially well suited to picking up this phenomenon.
 Quantitative models generally assume stable consumer
tastes. If tastes are actually changing, survey data can
suggest the nature and direction of such changes.

TREND ANALYSIS AND PROJECTION

Trend analysis is based on the premise that future economic performance


follows an established historical pattern.

1. Trends in Economic Data

Trend projection is predication (expression) on the assumption that


historical relationships will continue into the future. All such methods
use time-series data. Weekly, monthly, or annual series of data on sales
and costs, personal income, population, labor force participation rates,
and GDP are all examples of economic time series.

 Secular Trend - is the long-run pattern of increase or decrease in


a series of economic data

 Cyclical Fluctuation - describes the rhythmic variation in


economic series that us due to a pattern of expansion or
contradiction in the overall economy.

 Seasonal variation or Seasonality - a rhythmic annual pattern in


sales or profits caused by weather, habit or social custom.

 Irregular or random influences - are unpredictable shocks to the


economic system and the pace of economic activity caused by
wars, strikes, natural catastrophes and so on.

Time- series analysis can be as simple as projecting or extrapolating an


unadjusted trend. When one applies either simple graphic analysis or least
squares regression techniques, historical data can be used to determine the
average increase or decrease in the series during each period and then
projected into the future.

2. Linear Trend Analysis

Linear trend analysis assumes a constant period-by-period unit change in


an important economic variable over time.

3. Growth Trend Analysis

Growth trend analysis assumes a constant period-by-period percentage in


an important economic variable over time. This model is appropriate for
forecasting when sales appear to change over time by a constant proportional
amount rather than by the absolute amount assumption implicit in a simple
linear method.
Sales in t Years = Current Sales x (1 + Growth Rate) ^t

St= So (1+ g) ^t

4. Linear and Growth Trend Comparison

BUSINESS CYCLE

One of the most important economy-wide considerations for managers is the


business cycle, or rhythmic pattern of contraction and expansion observed in the
overall economy.

ECONOMIC INDICATORS

Economic indicators are data that describe projected, current, or past


economic activity.

COMPOSITE INDEX

A composite index is a weighted average of leading, coincident, or lagging


economic indicators. Keep in mind that the weights (standardization factors) used
in the construction of these composite indices vary over time. Combining
individual data into a composite index creates a forecasting series with less
random fluctuation, or noise. These composite series are smoother than the
underlying individual data series and less frequently produce false signals of
change in economic conditions.

ECONOMIC RECESSIONS

An economic recession is defined by the National Bureau of Economic


Research (NBER), a private nonprofit research organization, as a significant
decline in activity spread across the economy that lasts more than a few months.
Recession is a period of diminishing economic activity rather than a period of
diminished economic activity. A recession begins just after the economy reaches a
peak of output and employment and ends as the economy reaches its trough. The
period between a month of peak economic activity and the subsequent low point
defines the length of a recession. During recession, economic growth is falling or
the economy is actually contracting.

ECONOMIC EXPANSION

This is the period after recession, the rising of economic activity. Economic
activity is below normal during both recessions and through the early part of the
subsequent economic expansion.

SOURCES of FORECAST INFORMATION

The National Bureau of Economic Research, Inc. (NBER), founded in 1920, is


a private, nonprofit, nonpartisan research organization dedication to promoting a
greater understanding of how the economy works.

EXPONENTIAL SMOOTHING

Exponential smoothing is a method for forecasting trends in unit sales, unit


costs, wage expenses and so on. The technique identifies historical patterns of
trend or seasonality in the data and then extrapolates these patterns forward into
the forecast period. This is the averaging method for forecasting time series of
data. The more regular the pattern of change in any given data series, the easier
to forecast. It is the most widely used forecasting method in business.

Trend is any systematic change in the level of the time series of data. To
ensure that the correct exponential smoothing technique is chosen, a method with
sufficient flexibility to conform to the underlying data must be used. A good first
step in the exponential smoothing process is to graph the data series to be forecast
and then choose the exponential smoothing method that best resembles the data.

 ONE-PARAMETER (SIMPLE) EXPONENTIAL SMOOTHING

In one-parameter exponential smoothing, the sole regular component is the


level of the forecast data series. It is implicitly assumed that the data consist of
irregular fluctuations around a constant or very slowly changing level. Simple
exponential smoothing is appropriate for forecasting sales in mature markets
with stable activity; it is inappropriate for forecasting in markets that are
growing rapidly or are seasonal.

In the simple exponential smoothing model, each smoothed estimate of a


given level is computed as a weighted average of the current observation and past
data. Each weight decreases in an exponential pattern. The rate of decrease in the
influence of past level depends on the size of the smoothing parameter that
controls the model’s relative sensitivity to newer versus older data. The larger the
value of the smoothing parameter, the more is the emphasis placed on recent
versus distant observations. However, if the smoothing parameter is very small,
then a large number of data points receive nearly equal weights, In this case, the
forecast model displays a long “memory” of past values.

This is not appropriate for forecasting data that exhibit extended trends.

 TWO-PARAMETER (HOLT) EXPONENTIAL SMOOTHING

In two-parameter exponential smoothing, the data are assumed to consist of


fluctuations about a level that is changing with some constant or slowly drifting
linear trend. It is named after its originator C. C. Holt. It is appropriate for
forecasting sales in established markets with stable growth; but inappropriate in
either stable or rapidly growing markets.

This exponential smoothing uses a smoothed estimate of the trend component


as well as the level component to produce forecasts. The current smoothed level is
added to a linear trend to forecast future values. The updated value of the
smoothed level is computed as the weighted average of new data and the best
estimate of the new level based on old data. Holt method combines old and new
estimates of the one-period change of the smoothed level, thus defining the
current linear or local trend.

 THREE-PARAMETER (WINTERS) EXPONENTIAL SMOOTHING

This method extends the two-parameter technique by including a smoothed


multiplicative index to account for the seasonal behavior of the forecast series. It’s
originator is P.R. Winters. It is one of the most commonly used forecasting
methods. It is best suited for forecasting problems that involve rapid and/or
changing rates of growth combined with seasonal influences.

This model assumes that each observation is the product of a deseasonalized


value and a seasonal index for that particular month or quarter. The Winters
model forecast is computed similarly to the Holt Model forecast and then
multiplied by the seasonal index for the current period.
ECONOMETRIC FORECASTING

Econometric methods combine economic theory with statistical tools to


predict economic relations.

Econometric methods force the forecaster to make explicit assumptions about


the linkages among the variables in the economic system beings examined. The
forecaster must deal with causal relations. This produces logical consistency in
the forecast model and increases reliability.

 SINGLE- EQUATION MODELS

The first step in developing an econometric model is to express relevant


economic relations in the form of an equation.

C= demand

P= price

I= disposable income

Pop= population

i= interest rates

A= advertising expenditures

C=ao + a1P +a2I + a3Pop + a4i + a5A

The second step is to estimate the parameters of the system, or values of


the coefficients.

 MULTIPLE-EQUATION SYSTEMS