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Francis X. Diebald University of Pennsylvania THOM* SON SOUTH-WESTERN Australia'' Brazil Canaoa Mexico • Singapore Spam United Kingdom - United States THOM* SON SOUTH-WESTERN Elements of Forecasting, Fourth Edition Francis X. Diebold VP/Editorial Director: Content Project Manager: Art Director: Jack W. Calhoun Elycia Arendt Michelle Kunkler VP/Editor-in-Chief: Manager of Technology, Editorial: Cover Designer: Alex von Rosenberg John Barans Craig Ramsdell, Ramsdell Design Sr. Acquisitions Editor: Technology Project Manager: Cover Image: Mike Worts Dana Cowden © Getty Images, inc. Developmental Editor: Sr. Manufacturing Coordinator: Printer: Leslie Kauffman, LEAP Sandee Milewski Thomson/West Marketing Manager: Production House: Jenny Garamy Interactive Composition Corporation Editorial Assistant: Jessica Hartman COPYRIGHT © 2007, 2004 ALL RIGHTS RESERVED. Library of Congress Control Number: Thomson South-Westem, a part of The No part of this work covered by the 2006909336 Thomson Corporation. Thomson, the copyright hereon may be reproduced or Star logo, and South-Western are used in any form or by any means— For more information about our trademarks used herein under license. graphic, electronic, or mechanical, products, contact us at: including photocopying, recording, Thomson Learning Academic Printed in the United States of America taping, Web distribution or information Resource Center 3 4 5 09 08 07 storage and retrieval systems, or in any 1-800-423-0563 other manner—without the written ISBN-13: 978-0-324-32359-7 (package) permission of the publisher. Thomson Higher Education ISBN-10:0-324-32359-X (package) 5191 Natorp Boulevard ISBN-13: 978-0-324-35904-6 (book only) For permission to use material from this Mason, OH 45040 ISBN-10:0-324-35904-7 (book only) text or product, submit a request online USA at http://www.thomsonrights.com. THE LIBRARY UNIVERSITY OF GUELPrf To Lawrence Klein, Marc Nerlove, and Peter Pauly, who taught me forecasting. Most good texts arise from the desire to leave one's stamp on a discipline by training future generations of students, coupled with the recognition that ex isting texts are inadequate in various respects. My motivation is no different. There is a real need for a concise and modern introductory forecasting text. A number of features distinguish this book. First, although it uses only ele mentary mathematics, it conveys a strong feel for the important advances made since the work of Box and Jenkins more than 30 years ago. In addition to standard models of trend, seasonality, and cycles, it touches—sometimes extensively—upon topics such as • data mining and in-sample overfitting • statistical graphics and exploratory data analysis • model selection criteria • recursive techniques for diagnosing structural change • nonlinear models, including neural networks • regime-switching models • unit roots and stochastic trends • smoothing techniques in their relation to stochastic-trend unobserved- components models • vector autoregressions • cointegration and error correction • predictive causality • forecast evaluation and combination • simulation and simulation-based methods • volatility measurement, modeling, and forecasting Preface v Much of that material appears in the "Exercises, Problems, and Comple ments" following each chapter, which form an integral part of the book. The Exercises, Problems, and Complements are organized so that instruc tors and students can pick and choose according to their backgrounds and interests. Second, the book does not attempt to be exhaustive in coverage. In fact, the coverage is intentionally selective, focusing on the core techniques with the widest applicability'. The book is designed so that it can be covered re alistically in a one-semester course. Core material appears in the main text, and additional material that expands on the depth and breadth of coverage is provided in the Exercises, Problems, and Complements, as well as the Biblio graphical and Computational Notes, at the end of each chapter. Third, the book is applications-oriented. It illustrates all methods with de tailed real-world applications designed to mimic typical forecasting situations. In many chapters, the application is the centerpiece of the presentation. In various places, the book uses applications not simply to illustrate the methods but also to drive home an important lesson, the limitations of forecasting, by presenting truly realistic examples in which not everything works perfectly! Fourth, the book is in touch with modern modeling and forecasting software. It uses Eviews, which is a good modern computing environment for forecasting, throughout. At the same time, I am not a software salesman, so the discussion is not wed to any particular software. Students and instructors can use whatever computing environment they like best. The book has found wide use among students in a variety of fields, includ ing business, finance, economics, public policy, statistics, and even engineer ing. The book is directly accessible at the undergraduate and master's levels; the only prerequisite is an introductory statistics course that includes linear re gression. To help refresh smdents' memories, Chapter 2 reviews linear regres sion from a forecasting perspective. The book is also of interest to those with more advanced preparation, because of the hard-to-find direct focus on fore casting (as opposed, for example, to general statistics, econometrics, or time series analysis). I have used it successfully for many years as the primary text in my undergraduate forecasting course, as a background text for various other undergraduate and graduate courses, and as the primary text for master V level Executive Education courses given to professionals in business, finance, economics, and government. SUPPLEMENTS Data Sets and Eviews Programs Selected data and Eviews programs, as used both in the text chapters and in the Exercises, Problems, and Complements at the end of each chapter, are available on the text Web site at www.thomsonedu.com/economics/diebold. Preface Text Web Site The text Web site at www.thomsonedu.com/economics diebold provides teaching resources, including the solutions manual for instructors; learning resources, including data sets and Eviews programs; and many more features. Solutions Manual Prepared by Francis Diebold, University of Pennsylvania, the solutions manual contains remarks, suggestions, hints, and solutions for many of the end-of- chapter exercises, problems, and complements. It is available on the text Web site and may be downloaded for use by adopting instructors. Eviews Software Upon the instructor's request, Eviews Student Version can be bundled with the text. With Eviews, students can do homework anywhere they have access to a PC. For more information on this special Eviews offer, contact your Thomson South-Western representative or call the Academic Resource Center at 1-800-423-0563. Economic Applications Economic Applications includes South-Western's dynamic Web features: EronNews, EconDebate, and EconData Online. Organized by pertinent eco nomic topics and searchable by topic or feature, these features are easy to integrate into the classroom. EconNews, EconDebate, and EconData all deepen students' understanding of theoretical concepts through hands-on ex ploration and analvsis for the latest economic news stories, policy debates, and data. These features are updated on a regular basis. For more information, visit wwwthomsonedu.com. InfoTrac With InfoTrac College Edition, students can receive anytime, anywhere online access to a database of full-text articles from thousands of popular and schol arly periodicals, such as Xeivsnwk, Fortune, and Nation's Business, among others. InfoTrac is a great wax to expose students to online research techniques, with the securitv that the content is academically based and reliable. For more in formation, xisit www.ihomsonedu.com. You can start using manv of these resources right away by following the di rections on the access card that came with the purchase of a new book. Get started today at www.thomsonedu.com! Preface vii ACKNOWLEDGEMENTS Many people have contributed to the development of this book—some explicitly, some without knowing it. One way or another, all of the following deserve thanks: Joan B. Anderon Robert F. Engle University of Sun Diego University of California, San Diego Scott Armstrong Farzad Farsio I!n wersity of Pen nsytvan in Montana State University, Billings Alan Auerbach Robert Fildes University of California. Berkeley University of Lancaster David Bivin Jessica Gamburg Indiana University-Purdue University at Heitman Indianapolis Antonio Garcia-Ferrer Gregory A. Charles Universidad Autonoma de Madrid Oregon Health Csf Science University Patrick A. Gaughan Chris Chatfield Farleigh-Dickenson University University of Bath Give Granger Jen-Chi Cheng University of California, San Diego Wichita State University Craig Hakkio Sidhartha Chib Federal Reserve Bank of Kansas City Washington University in St. Louis Eric Hillebrand Peter Christoffersen Louisiana State University McGilf Lhi wersity Eric C. Howe Jorg Clostei mann Un iversity of Saskatcheiua n Unix>ersity of Applied Sciences, Der An Hsu Fachhochsch it le Ingolsladt University of Wisconsin, Milwaukee Dean Croushore Lawrence R. Klein Federal Reserve Bank of Philadelphia University of Pen nsylvania Robert A. Dickler James Kozik IMADKC University SPSS, Inc. Tom Doan Junsoo Lee Estima University of Alabama Michael Donihue Tae-Hwy Lee Colby College University of California, Riverside Jean-Marie DuFour David Lilien University of Montreal Unwersity of California, Irvine Jeffrey Edwards Jose Lopez Texas Tech University Federal Reserve Bank of New York Preface Ron Michener James H. Stork University of Virginia Harvard University Ray Nelson Mark Strazicich Brigham Young University University of Central Florida Caitlin O'Neil Norman Swan son Goldman, Saclis & Co. Texas AcrM i Diversity Llad Phillips Hirokuni Tamura University of California, Santa Barbara University of Washington W. Robert Reed George Tavlas University of Oklahoma Bank of Greece Russell Robins Hiroki Tsurumi Tulane University Rutgers University Philip Rothman William Veloce East Carolina University Brock University Glenn D. Rudebusch Mark W. Watson Federal Reserve Bank of San Francisco Pn n ceton 17n n >eisity Robert Rycroft Barry Wreller Mary Washington College Penn State University, Erie Richard Saba Kennedi D. West Auburn University University of Wisconsin John H. Shannon Koichi Yoshimine Royal Melbourne Institute of Technology University of British Columbia Steven Shwiff Toshiyuki Yuasa Texas A&M University-Commerce University of Houston Gokce Soydemir Tao Zha University of Texas, PanAmerican Federal Reserve Bank of Atlanta Robert Stine University of Pennsylvania I am especially grateful to all members of the Thomson South-Western team, past and present, including Elycia Arendt, Jennifer Baker, Jack Calhoun, Jennifer Garamv, Dennis Hanseman, Leslie Kauffman, and Michael Worls, without whose encouragement and guidance this book would not have been written. I am similarly grateful to the many energetic undergraduate and grad uate student assistants that I have had over the vears, who read and improved much of the manuscript, including Boragan Aruoba, Adam Buresh, Morris Davis, Atsushi Inoue, John Schindler, Eric Schwartz, Chiara Scotti, Georg Strasser, Anthony Tay, Karen Toll, and Ginger Wu. Finally. I apologize and accept full responsibility for the many errors and shortcomings that undoubtedly remain—minor and major—despite ongoing efforts to eliminate them. The fourth edition maintains the emphasis of earlier editions on providing an intuitive building-block approach to the development of modern and practi cal methods for producing, evaluating, and combining forecasts. Within that framework, several improvements have been implemented, including 1. Enhanced and extended discussion of the elements of probability and sta tistics of maximal relevance to forecasting, now included as a separate Chapter 2, 2. Many new exercises, problems, and complements, which emphasize practi cal implementation of the methods developed in the text, including sim ple drills to check understanding, 3. Selectively reworked and/or rearranged material, to maximize clarity and pedagogical effectiveness. Throughout, my intent has been to insert and delete where needed, sparingly, avoiding the temptation to fix parts "that ain't broke." Hopefully I have moved forward. F.X.D August 2006 ix