Forgetting Approaches to Improve Forecasting

Paulo Rodrigues and Robert Hill

Working Papers from Banco de Portugal, Economics and Research Department

Abstract: There is widespread evidence of parameter instability in the literature. One way to account for this feature is through the use of time-varying parameter (TVP) models that discount older data in favour of more recent data. This practise is often known as forgetting and can be applied in several different ways. This paper introduces and examines the performance of different (flexible) forgetting methodologies in the context of the Kalman filter. We review and develop the theoretical background and investigate the performance of each methodology in simulations as well as in two empirical forecast exercises using dynamic model averaging (DMA). Specifically, out-of-sample DMA forecasts of CPI inflation and S&P500 returns obtained using different forgetting approaches are compared. Results show that basing the amount of forgetting on the forecast error does not perform as well as avoiding instability by placing bounds on the parameter covariance matrix.

JEL-codes: C22 C51 C53 (search for similar items in EconPapers)
Date: 2022
New Economics Papers: this item is included in nep-dem, nep-ecm, nep-ets and nep-for
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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