Does foreign sector help forecast domestic variables in DSGE models?

Abstract

This paper evaluates the forecasting performance of several small open economy DSGE models relative to a closed economy benchmark using a long span of data for Australia, Canada and the United Kingdom. We find that opening the economy does not improve, and even deteriorates the quality of point and density forecasts for key domestic variables. We show that this result can be to a large extent attributed to an increase in forecast error due to a more sophisticated structure of the extended setup. This claim is based on a Monte Carlo experiment, in which an open economy model fails to consistently beat its closed economy benchmark even if it is the true data generating process.