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A multi-country dynamic factor model with stochastic volatility for euro area business cycle analysis

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Document pages: 24 pages

Abstract: This paper develops a dynamic factor model that uses euro area (EA)country-specific information on output and inflation to estimate an area-widemeasure of the output gap. Our model assumes that output and inflation can bedecomposed into country-specific stochastic trends and a common cyclicalcomponent. Comovement in the trends is introduced by imposing a factorstructure on the shocks to the latent states. We moreover introduce flexiblestochastic volatility specifications to control for heteroscedasticity in themeasurement errors and innovations to the latent states. Carefully specifiedshrinkage priors allow for pushing the model towards a homoscedasticspecification, if supported by the data. Our measure of the output gap closelytracks other commonly adopted measures, with small differences in magnitudesand timing. To assess whether the model-based output gap helps in forecastinginflation, we perform an out-of-sample forecasting exercise. The findingsindicate that our approach yields superior inflation forecasts, both in termsof point and density predictions.

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