Economic forecast is the prediction of values of a broad set of economic variables. Forecasts are used by businesses and governments to make strategic decisions. They are also used by market participants to estimate the value of stocks and other assets. In the context of monetary policy, forecasts can be used to inform interest rate setting.
There are several complexities that arise in making and evaluating economic forecasts. Firstly, forecasts are usually measured over long horizons, and the first published estimates may not match up with the final realized values for some time. For example, the initial published estimates of gross domestic product (GDP) and employment are typically revised multiple times in subsequent years.
Furthermore, the nature of the economic process is essentially stochastic. This implies that the probability distribution of the outcome of a policy decision may be influenced by a number of external factors. This has implications for how well a forecasting model can capture the underlying structure of the economy, and how accurate the model can be at predicting the outcome of a policy decision.
The rational expectations revolution of the 1970s highlighted a conceptual issue with this approach, suggesting that the estimated behavior of economic variables might be influenced by policy choices (Lucas critique). The poor performance of many large macro models at that time raised doubts about the validity of using them for forecasting purposes. Since then, the literature has explored a wide range of alternative methodologies, from simple autoregressive models to estimated dynamic stochastic general equilibrium (DSGE) models.
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