Forecasting and Policy Making (Paper) - Center for Financial Studies

it turns negative because real GDP declined and at the same time potential output increased. In
2010 the output gap comes close to zero as real GDP grew again and potential output declined. The
forecast for the output gap is slightly above zero as real GDP is predicted to grow somewhat faster
than potential GDP. In this model potential GDP and thus also the output gap have a clear structural
interpretation. While in the previous small structural model potential GDP was modeled as a trend,
potential output here is defined as the level of output and expenditure that would be realized in the
absence of price and wage rigidities and price and wage mark-up shocks.
Using a decomposition in historical shocks for forecast interpretation
To analyze which shocks played an important role during the financial crisis and recession, and
to investigate which have of them have a lasting impact over the current forecast, we compute a
historical decomposition. Using the moving average representation of the model solution, we eval-
uate how much each type of shock contributes to a particular variable at each point in time over the
sample period and over the forecast period. The model contains seven shocks: risk premium shock,
investment-specific technology shock, technology/supply shock, monetary policy shock and price and
wage mark-up shocks. Figure 13 displays the decomposition of historical annualized quarterly out-
put growth and its forecasts. The bars for each period summarize the contributions of all shocks to
output growth, some of them positive some negative. The areas with different textures identify the
size of the contribution of each type of shock.
In addition to the shocks, the label of the chart refers to two more contributions to growth termed
”starting values” and ”population growth”. The bars labeled starting values appear because data is
not available for an infinite past history, and therefore shock realizations cannot be recovered from an
infinite past. Thus, the ”starting values” bar indicates the impact of the initial conditions. The effect
of initial conditions turns out to be negligible over the period shown in Figure 13.
DSGE models are usually defined in per capita terms. However, policy makers are more interested
in aggregate growth rates. Therefore, the black solid-line indicates overall real GDP growth rather
than per capita growth. Consequently, part of the GDP growth is due to population growth. This
contribution is indicated by the ”population growth” bars. As population growth is not defined in
the model, we simply assume for the forecast that the population growth rate equals the average
population growth rate in 2009 and 2010. The horizontal axis indicates the steady-state per capita
growth rate. For long-run forecasts the impact of the shocks will disappear and per capita growth will
converge to this estimated steady state growth rate.
The positive and negative contributions from shocks, population growth and starting values sum up
to the actual output growth rate (black line) over the sample period and to the predicted output growth
rate over the forecast period. Interestingly, the deep recession of 2008 and 2009 is largely attributed
to the combination of substantial (positive) risk premium shocks and negative investment shocks.
The contribution of these two types of shocks is lumped in the left shaded area of the contribution
bars. In other words, the recession, which was not predicted by the model, is explained as being due
to a sequence of unexpectedly high risk premia realizations together with unexpected shortfalls of
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