Evaluating the forecasting accuracy of the closed- and open economy New Keynesian DSGE models

The primary purpose of this paper is to compare the forecasting performance of a small open economy New Keynesian Dynamic Stochastic General Equilibrium (SOE-NK-DSGE) model with its closed-economy counterpart. Based on the quarterly Australian data, these two competing models are recursively estimated, and point forecasts for seven domestic variables are compared. Since Australia is a small open economy, global economic integration and financial linkage play an essential role in this country. However, the empirical findings indicate that the open economy model yields predictions that are less accurate than those from its closed economy counterpart. Two possible reasons could cause this failure of the SOE-NK-DSGE model: (1) misspecification of the foreign sector, and (2) a higher degree of estimation uncertainty. Thus, this research paper examines further how these two issues are associated with this practical problem. To this end, we perform two additional exercises in a new variant of the SOE-NK-DSGE and Bayesian VAR models. Consequently, the findings from these two exercises reveal that a combination of misspecification of the foreign sector and a higher degree of estimation uncertainty causes the failure of the open economy DSGE model in forecasting. Thus, one uses the SOE-NK-DSGE model for prediction with caution.