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Bayesian Forecasting of Economic Time Series

Published online by Cambridge University Press:  11 February 2009

Bruce M. Hill
Bruce M. Hill
Affiliation:
University of Michigan
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Abstract

A model is suggested to forecast economic time series. This model incorporates some innovative ideas of Harrison and Stevens [20] for building into the forecasting process important external shocks to the systems. Thus the occurrence of possibly significant real-world events may cause a fundamental change in the time series in question. The Jeffreys-Savage (JS) Bayesian theory of hypothesis testing is used to test the hypothesis that a particular event has been such as to free the series from its immediate past behavior. When the event frees the series in this way, then we model the sequence of observations following such an event (until the next such event) as an exchangeable sequence. In the simplest case of 0–1 valued data, such as in recording the ups and downs of the value of a particular commodity or stock, our alternative hypothesis is a Pólya process, and the null hypothesis is a simple random walk (unit roots model) with p = .50. Any exchangeable sequence is strictly stationary, and the observations in the Polya process are positively correlated, which can give rise to “explosive” behavior of the series at isolated time points. We then use the JS theory to predict future observations by taking a weighted average of the optimal predictions for each model, with weights given by the posterior probabilities of the hypotheses. Results of simulation studies are presented which compare the predictive performance of the fully Bayesian method based upon the JS theory with those based upon the “p-value” or pre-test method. The de Finetti method for scoring predictions is used to assess their empirical performance. A theoretical methodology, which extends the “evaluation game” of Hill [28,37], is developed for comparing predictors.

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Econometric Theory , Volume 10 , Issue 3-4 , August 1994, pp. 483 - 513
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Copyright © Cambridge University Press 1994

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