Abstract
AbstractWe investigate the optimal constituent variable weighting method for a UK financial conditions index (FCI) using a small number of financial indicators. The criterion for choosing the optimal weighting model concentrates on the index's ability to predict economic activity. We develop a “two‐step” process as a new weighted‐sum method and show that it is superior to other existing weighted‐sum models in creating an FCI. For comparative purposes, we create another FCI using a time‐varying parameter factor‐augmented vector autoregressive (TVP‐FAVAR) with stochastic volatility model as a principal‐component method. The results suggest that the TVP‐FAVAR model is the best variable‐weighting model to create an FCI in relation to its purpose of forecasting developments in the economy.
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