Forecasting macroeconomic variables in a small open economy: a comparison between small‐ and large‐scale models

This paper compares the forecasting ability of five alternative types of models in predicting four key macroeconomic variables, namely, per capita growth rate, the CPI inflation, the money market rate, and the growth rate of the nominal effective exchange rate for the South African economy. Unlike the theoretical small open economy new Keynesian dynamic stochastic general equilibrium, the unrestricted VAR, and the small‐scale Bayesian vector autoregressive models, which are estimated based on four variables, dynamic factor models and the large‐scale BVAR models use information from a data‐rich environment containing 266 macroeconomic time series observed over the period 1983:01 to 2002:04. The results, based on root mean square errors, for one‐ to eight‐quarter‐ahead out‐of‐sample forecasts over the horizon of 2003:01 to 2006:04, show that, except for the growth rate of the of nominal effective exchange rate, large‐scale BVARs outperform the other four types of models consistently and, generally, significantly.