A Structural Approach to Combining External and DSGE Model Forecasts

This note shows that combining external forecasts such as the Survey of Professional Forecasters can significantly increase DSGE forecast accuracy while preserving the interpretability in terms of structural shocks. Applied to pseudo real-time from the second quarter of 1997 onward, the canonical Smets and Wouters (2007) model has significantly smaller forecast errors when giving a high weight to the SPF forecasts. Incorporating the SPF forecast gives a larger role to risk premium shocks during the global financial crisis. A model with financial frictions favors a larger weight on the DSGE model forecast.