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The Role Of Financial Variables In Predicting Economic Activity

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Executive Summary

Previous research has shown that the US business cycle leads the European cycle by a few quarters, and can therefore help predicting euro area GDP. The authors investigate whether financial variables provide additional predictive power. They use a VAR model of the US and the euro area GDPs and extend it to take into account common global shocks and information provided by selected combinations of financial variables. In-sample analysis shows that shocks to financial variables influence real activity with a peak around 4 to 6 quarters after the shock. Out-of-sample Root-Mean-Squared Forecast Error (RMFE) shows that adding financial variables yields smaller errors in forecasting US economic activity, especially at a five-quarter horizon, but the gain is overall tiny in economic terms.

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