A SUGGESTION FOR
A DYNAMIC MULTI FACTOR MODEL (DMFM)
Heather D. Gibson
Bank of Greece
Stephen G. Hall
University of Leicester, Bank of Greece and
University of Pretoria
George S. Tavlas
Bank of Greece and Hoover Institution, Stanford
University
ABSTRACT
We provide a new
way of deriving a number of dynamic unobserved factors from a set of variables.
We show how standard principal components may be expressed in state space form
and estimated using the Kalman filter. To illustrate our procedure we perform
two exercises. First, we use it to estimate a measure of the current-account imbalances
among northern and southern euro-area countries that developed during the
period leading up to the outbreak of the euro-area crisis, before looking at
adjustment in the post-crisis period. Second, we show how these dynamic factors
can improve forecasting of the euro-dollar exchange rate.
Keywords:
Principal Components, Factor Models, Underlying activity, Forecasts
JEL Classification: E3,
G01, G14, G21
Acknowledgements:
We are very grateful to Apostolis Serletis, the Associate Editor, and two
referees for constructive comments on an earlier draft. The views expressed in
this paper are the authors’ own and do not necessarily represent those of the
institutions with which they are affiliated.
Correspondence:
George Tavlas
Alternate to the Governor of the Bank of Greece on the ECB Governing Council and Distinguished Visiting Fellow at the Hoover Institution, Stanford University
Bank of Greece
21 E Venizelos Ave
Athens, 10250, Greece
Tel. no. +30 210 320 2370
Fax. no. +30 210 320 2432
Email address: gtavlas@bankofgreece.gr