Economic theory and forecasting: Lessons from the literature

Does economic theory help in forecasting key macroeconomic variables? This article aims to provide some insight into the question by drawing lessons from the literature. The definition of "economic theory" includes a broad range of examples, such as accounting identities, disaggregation and spatial restrictions when forecasting aggregate variables, cointegration and forecasting with Dynamic Stochastic General Equilibrium (DSGE) models. We group the lessons into three themes. The first discusses the importance of using the correct econometric tools when answering the question. The second presents examples of theory-based forecasting that have not proven useful, such as theory-driven variable selection and some popular DSGE models. The third set of lessons discusses types of theoretical restrictions that have shown some usefulness in forecasting, such as accounting identities, disaggregation and spatial restrictions, and cointegrating relationships. We conclude by suggesting that economic theory might help in overcoming the widespread instability that affects the forecasting performance of econometric models by guiding the search for stable relationships that could be usefully exploited for forecasting. ∗I thank Richard Smith and an anonymous referee for useful comments and suggestions and gratefully acknowledge financial support from the Economic and Social Research Council through the ESRC Centre for Microdata Methods and Practice grant RES-589-28-0001. Address correspondence to Raffaella Giacomini, University College London, Department of Economics, Gower Street, London WC1E6BT, UK; e-mail: [email protected].