School of Economics and Finance

No. 720: Adaptive Models and Heavy Tails

Davide Delle Monache , Queen Mary University of London
Ivan Petrella , Birkbeck, University of London and CEPR

July 1, 2014

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This paper proposes a novel and flexible framework to estimate autoregressive models with time-varying parameters. Our setup nests various adaptive algorithms that are commonly used in the macroeconometric literature, such as learning-expectations and forgetting-factor algorithms. These are generalized along several directions: specifically, we allow for both Student-t distributed innovations as well as time-varying volatility. Meaningful restrictions are imposed to the model parameters, so as to attain local stationarity and bounded mean values. The model is applied to the analysis of inflation dynamics. Allowing for heavy-tails leads to a significant improvement in terms of fit and forecast. Moreover, it proves to be crucial in order to obtain well-calibrated density forecasts.

J.E.L classification codes: C22, C51, C53, E31

Keywords:Time-varying parameters, Score-driven models, Heavy-tails, Adaptive algorithms, Inflation