forecasting the recession

Canada’s Financial Future

Created by Kirsten Boer, Shannon Hamilton & Gretl

The Canadian Business Cycle

Agenda

1. Overview of Topic

2. Economic Theory

3. Data & Methods

4. Empirical Results & Sensitivity Analysis

5. Practical Applications

6. Summary

Overview of Topic

What is the future path of Canada’s

Business Cycle? Is Canada’s

economy currently contracting?

Economic Theory Data & MethodsOverview SummaryResults Application

In the News


OECD warns of worst recession since early 1980sOECD says developed world could face worst recession since early 1980s; warns of

deflation

Economic contraction in Canada will be short-lived: Royal Bank

U.S. economic woes not necessarily Canada's fate

Business Cycles

Business cycle: “fluctuations of aggregate economic activity”, which consists of 4 stages: contraction, trough,

expansion & peak


Peak

Trough

Business Cycles: Burns & Mitchell


Business Cycles are recurrent, but not

periodic

Factors that affect

business cycles have regular patterns of

behavior

Theory suggests an

ARIMA model would not be

suitable

ARIMA & GDP’s Growth Path


Classes of Economic Variables


LaggingCoincidentLeading

Variable’s turning

point occurs before

the business cycle


point occurs at

the same time as

the business cycle


point occurs after

the business cycle

Theory suggests the appropriate lag length of different variables

Classes of Economic Variables


CountercyclicalAcyclicalProcyclical

Variable moves in

the same direction

as the business

cycle

Variable does not

move with the

business cycle

(e.g. real interest

rates)

Variable moves in

the opposite

direction as the

business cycle

Theory suggests the coefficient sign of different variables

Considered Variables


GDP= C + I + G + NX

•Durable consumption

• Stock index prices

•Capital Investment • Trade Balance

• CA Balance

•Exchange rates

•Government Spending on G&S

Other considered Variables: Bank of Canada Interest rate, Labour productivity, inflation (CPI), unemployment, MB1, mortgage rates

What period should be used?

• 1996:1 to 2006:1

• Allows for a hold-out period

• Uses data that best matches the current structural relationship between the independent variables and the dependent variable


Is the Data Stationary?


GDP Labour Productivity

Industrial Production Capital Investment

Is the Data Stationary?


Exchange Rate

Correlation Matrix


d_lab d_industprod d_exchange d_kinvest

1.000 0.3725 -0.0107 -0.1914 d_lab

1.000 -0.1136 -0.0106 d_industprod

1.000 0.1563 d_exchange

1.000 d_kinvest

Correlation Coefficients, using the observations 1996:1 - 2006:1

Chosen Model


coefficient std. error t-ratio p-value --------------------------------------------------------------

const 3382.92 928.731 3.643 0.0010 *** d_lab 4419.39 1049.81 4.210 0.0002 ***

d_industprod_1 0.524218 0.0982486 5.336 9.03E-06 *** d_Exchange_1 !797.298 213.312 !3.738 0.0008 *** d_kInvest_1 0.302776 0.0367233 8.245 3.34E-09 ***

Unadjusted R-squared = 0.86446 Adjusted R-squared = 0.84698

Mean of dependent variable = 9501.31 Standard deviation of dep. var. = 5024.55 Sum of squared residuals = 1.19761e+08

Standard error of the regression = 1965.52

F-statistic (4, 31) = 93.4873 (p-value < 0.00001)

Review of Parameter Signs


Variable Sign Reasoning

d_labour + Labour is better utilized in a period of economic prosperity

d_industrialprod_1 + Firms produce more when the economic outlook is good

d_exchange_1 -Canada is a net export country; as the change in the exchange rate falls, Canadian exports become more

attractive

d_kinvestment_1 + Firms invest more when the economic outlook of Canada is good

Specification Tests


Test Output Result

Ramsey RESET p-value=0.2706 DNR Null Hypothesis

White Test p-value=0.3597 DNR Null Hypothesis

Breusch-Godfrey p-value=0.166879 DNR Null Hypothesis

CUSUM/CUSUMSQGraph does not cross CI

BandsNo structural Break

In-Sample Forecast Accuracy


Measure Value

MFE 0.000625

MAFE 1408.3875

MSE 2678972.259

MPE 0.015954892

MAPE 0.1514023

Theil’s U 0.078145808

Hold-Out Period Forecast


Hold-Out Period Forecast Accuracy


Measure Value

MFE -1154.995

MAFE 2547.04

MSE 10054433.63

MPE -0.061863129

MAPE 0.219816721

Theil’s U 0.138125124

Out-of-Sample Forecast


Sensitivity Analysis

1. What if the future values of the independent variables were less volatile than expected?

2. What if government successfully increase capital investment?




-30000

-22500

-15000

-7500

0

7500

15000

22500

30000

2001:02:00 2002:01:00 2002:04:00 2003:03:00 2004:02:00 2005:01:00 2005:04:00 2006:03:00 2007:02:00 2008:01:00 2008:04:00 2009:03:00

Comparison of Different Change in GDP Predictions

d_GDP Initial Prediction

Alternate Prediction (1) Alternate Prediction (2)

Independent Variables & Theory


1. Labour Productivity2. Industrial Production 3. Exchange Rate 4. Capital Investment

1. Leading/ Procyclical2. Coincident/ Procyclical3. No theoretical view4. Coincident/ Procyclical

Theory SuggestsIndependent Variables

Independent Variables & Theory


1. Labour Productivity2. Industrial Production3. Exchange Rate4. Capital Investment

1. Coincident/ Procyclical2. Lagging/ Procyclical3.Lagging/Countercyclical4. Lagging/ Procyclical

Model SuggestsIndependent Variables

ARIMA Forecasting Accuracy


Measure Value

MFE -2,161.71

MAFE 3,538.348

MSE 17,710,115

MPE -0.318

MAPE 0.425088

Theil’s U 0.163985

ARIMA vs. OLS Model


Our findings match

Burns & Mitchell’s Theory

ARIMA provides a less accurate model

Macro-Level Application

Government’s Public Policy

Framework to Create Public

Policy

Direct Timeline Estimations

Analysis & Comparison Tool


Micro-Level Application

The Graduate Decision: School

or Work?

Trend Analysis

Economic Decision Criteria

Forecasted GDP values vs. Market Beliefs



Key Takeaways


1. GDP should begin to recover by the end

of 2008

2. Government should work to create

policies that aid in the recovery of

Canada’s economy

Questions?

forecasting the recession

Documents

economic woes

economic activity

data stationary

ofdeation economic contraction

economic outlook ofd

business cycles business

overview of topic

industprod d