ECON0022

Econometrics for Macro and Finance

Problem Set III
Dennis Kristensen

Autumn 2018

1 Practice Problems
1. Consider iterative forecasts over the horizon T + 1; :::; T + h using an AR(1)
model, Yt = + Yt 1 + "t , given data up to time T . We ignore parameter
uncertainty and treat the parameters and as known such that the iterative
forecast takes the form

YT +kjT = + YT +k 1jT ; k = 1; 2; :::; h;

where YT jT = YT . We wish to analyze the behaviour of the forecasts in the

stationary (j j < 1) and non-stationary ( = 1) case.

(a) Show that the …nal h-step ahead forecast, YT +hjT , can be expressed as
n o
YT +hjT = h YT + 1 + + 2 + ::: + h 1 :

[hint: Use backward recursion starting at time T + h and stopping at time

T]
(b) Use the above expression to argue that for long-horizon forecasts (h very
large):

If j j < 1 : YT +hjT = Y;
1
If = 1 : YT +hjT ! 1;

where YT +hjT ! 1 should be interpreted as YT +hjT exploding (increas-

ing in absolute value without any bound) as h ! 1. Interpret the above
results.
(c) Let eT +h be h-step ahead forecast error de…ned as:

eT +h = YT +h YT +hjT :

Expresss eT +h as a function of "T +1 ;P

:::; "T +h . [Hint: Use backward recur-
sion to show that YT +h = YT +hjT + hi=01 i "T +h i ]

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 (d) Show that
n o
2 2 2(h 1)
E [eT +h ] = 0; Var (eT +h ) = " 1+ + :::: :

What is the h-step MSFE for the iterative procedure using an AR(1)
model? What happens to the MSFE as h grows large?
(e) Explain how you could use the results in question (d) to construct a 95%
forecast interval for your h-period ahead point forecast.

2. Suppose we have obtained the following estimates of an ADL model for annual
US unemployment (unemp) using in‡ation (inf l) as additional preditor,

d t = 1:304 + :647unempt
unemp 1 + :184inf lt 1; ^ " = :883: (1)
(:490) (:084) ((:041)

(a) Suppose that unemp2012 = 7:8 and inf l2012 = 1:3. What is your forecast
of unemployment in 2013?
(b) Suppose the errors in the ADL model are normally distributed. Compute
a 95% and 67% forecast interval.
(c) Can you use the above ADL model to forecast employment for 2014?
Explain.
(d) You decide to build a model for in‡ation in addition to the above model
for unemployment. You …nd that an AR(1) model provides an adequate
description of in‡ation,
c lt = 1:277 + :665inf lt
inf 1; ^ " = :653: (2)
(:558) (:107)

Use eqs. (1)-(2) to compute a forecast of in‡ation and unemployment for

2014.
Note: the joint model for inf l and unemp as given in eqs. (1)-(2) is
a particular example of so-called Vector Autoregressive (VAR) models.
These allow for joint modelling of multiple economic time series.

3. Prove the following results:

(a) Let W be a random variable with mean W and variance 2 . Show that
W
for any constant c:
h i
E (W c)2 = 2W + ( W c)2 :

(b) Consider the problem of forecasting YT +1 using data on YT ; YT 1 ; :::. Let

denote fT +1jT denote some forecast of YT +1 based on YT ; YT 1 ; ::: Let
h i
2
M SF E = E YT +1 fT +1jT

2
 denote the unconditional mean squared forecast error associated with
fT +1jT . Show that M SF E is minimized w.r.t. fT +1jT at fT +1jT = E [YT +1 ].
Interpret the result.
(c) Consider instead the conditional mean squared forecast error associated
with fT +1jT ,
h i
2
M SF ET = E YT +1 fT +1jT jYT ; YT 1 ; ::: :

Show that M SF ET is minimized w.r.t. fT +1jT at fT +1jT = E [YT +1 jYT ; YT 1 ; :::].

Interpret the result.
(d) Which of the two forecasts, fT +1jT or fT +1jT , would you rather use? Ex-
plain.

4. Let Yt = log (GDPt ) be change in US log-GDP using USMacro_Quarterly.dta

available on Moodle under "Data Sets". The goal is to choose an appropri-
ate AR model for forecasting. After opening the data set in STATA, …rst set
time [tsset time] and then create Yt [gen lgdp = log(realgdp); gen dlgdp
=lgdp - L.lgdp].

(a) As a …rst way of choosing the number of lags for the AR model for Yt ,
compute the AIC and BIC and LR criteria for the given sample [this can
be done with the STATA command varsoc dlgdp - note that STATA call
the BIC criterion SBIC]. Which model(s) does each of the three criteria
recommend?
(b) As a second way of choosing the appropriate number of lags, we can use
the pseudo-forecast evaluation criterion.
To this end, we wish to compute rolling pseudo-forecasts as described in
the slides. To perform this in STATA, you need to use the STATA com-
mands that you …nd in the …le ’rolling forecast US-dgp.txt’ posted
on Moodle/Problem Sets which performs the forecast evaluation using an
AR(3) model.
The …rst part of the code says:
//Pseudo-forecast of dlgdp using AR(3) model for T=150,...,252.
gen f_dlgdp3=.
local start 150
local end 252
forv T=‘start’/‘end’ {
quietly regress dlgdp L(1/3).dlgdp in 1/‘T’
quietly replace f_dlgdp3 = _b[_cons] + _b[L1.dlgdp]*dlgdp[‘T’]
+ _b[L2.dlgdp]*dlgdp[‘T’-1] + _b[L3.dlgdp]*dlgdp[‘T’-2] in ‘T+1’/‘T+1’
The above code runs a loop over T = 150; 151; :::; 252, where for each value
of T STATA does the following:

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 i. Estimate an AR(3), Y^t = ^ T + ^ 1;=t Yt 1 + ^ 2;T Yt 2 + ^ 3;T Yt 3 , using
only observations fY1 ; :::; YT g.
ii. Compute Y^T +1jT = ^ T + ^ 1;T YT + ^ 2;T YT 1 + ^ 3;T YT 2 and save this
value in f_dlgdp3.
To perform steps (i)-(ii), copy the above part of the code from ’rolling
forecast US-dgp.txt’and paste it into the command prompt in STATA
(and press enter...).
If you open the Data Editor, you’ll see that the variable f_dlgdp3 has
been created containing the rolling pseudo-forecasts, Y^T +1jT .
(c) To visualize the performance of the AR(3) as forecast model, plot the
actual observed value of YT +1 together with its pseudo-forecasts. This can
be done with the command ’tsline dlgdp f_dlgdp3 if tin(1984q2,)’.
Does the AR(3) model appear to do a good job?
(d) Next, compute pseudo-RMSFE in STATA by de…ning a new variable which
is the di¤erence between by Y and Y^ , and compute its sample variance
[gen e3 = dlgdp - f_dlgdp3; summarize e3]
(e) Next, re-do questions (b)-(c), this time using an AR(1) model. This can
be done by copy-pasting the second part of the code in the txt …le rolling
forecast US-dgp.txt into the command line in STATA. This generates a
new variable f_dlgdp1 that contains the rolling forecasts using an AR(1)
model. Plot this new forecast vs. actual outcome, and compute the cor-
responding pseudo-RMSFE.
(f) We now have two pseudo-RMSFE’s - one using an AR(1) model, and one
using an AR(3) model. In terms of pseudo-RMSFE, which of the two
models would you recommend? How does this recommendation compare
to the model(s) chosen by AIC, BIC and LR, respectively, in question (a)?