Mind your Ps and Qs! Improving ARMA forecasts with RBC priors

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Kirdan Lees; Troy Matheson
Published as
Lees, Kirdan and Troy Matheson (2007). ‘Mind your ps and qs! Improving ARMA forecasts with RBC priors’, Economics Letters, Elsevier, Volume 96(2), Pages 275-281, DOI: https://doi.org/10.1016/j.econlet.2007.01.015.
We utilise prior information from a simple RBC model to improve ARMA forecasts of post-war US GDP. We develop three alternative ARMA forecasting processes that use varying degrees of information from the Campbell (1994) flexible labour model. Directly calibrating the model produces poor forecasting performance whereas a model that uses a Bayesian framework to take the model to the data, yields forecasting performance comparable to a purely statistical ARMA process. A final model that uses theory only to restrict the order of the ARMA process (the ps and qs), but that estimates the ARMA parameters using maximum likelihood, yields improved forecasting performance.