Testing the Interpretation of Indices in a Macroeconomic Index Model*

This paper discusses and contrasts different approaches to the construction of dynamic model> containing unobservables. It is argued that some analysis is easy IO cam out wing Dynamic Factor Analysis (DFA). a frequency domain technique, while other analysis is easier to carry clut in the context of a Dynamic Multiple Indicator-Multiple Cause Model (DYMIMIC), a time domain technique. An example is presented in which six macroeconomic variables are found to be connected by two common factors using DFA. The interpretation of these factors as ‘anticipated’ and ‘unanticipated’ aggregate demand is then tested using the DYMIMIC model. This intcrpr :tation is strongly rejected.