DP7508 Predicting recoveries and the importance of using enough information

Author(s): Xiaoming Cai, Wouter Den Haan
Publication Date: October 2009
Keyword(s): financial crisis, forecasting, great recession, unit root
JEL(s): c51, c53, e37
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7508

Several papers that make forecasts about the long-term impact of the current financial crisis rely on models in which there is only one type of financial crisis. These models tend to predict that the current crisis will have long lasting negative effects on economic growth. This paper points out the deficiency in this approach by analyzing the ability of "one-type-shock" models to correctly forecast the recovery from past economic downturns. It is shown that these models often overestimate the long-run impact of recessions and that slightly richer models that allow the effects of recessions to be both persistent and transitory predict recoveries much better.