A Shrinkage Factor-Augmented VAR for High-Dimensional Macro–Fiscal Dynamics

Kyriakopoulou, Dimitra (2025): A Shrinkage Factor-Augmented VAR for High-Dimensional Macro–Fiscal Dynamics.

Abstract

We propose a ridge-regularized Factor-Augmented Vector Autoregression (FAVAR) for forecasting macro–fiscal systems in data-rich environments where the cross-sectional dimension is large relative to the available sample. The framework combines principal-component factor extraction with a shrinkage-based VAR for the joint dynamics of observed macro–fiscal variables and latent components. Applying the model to Greece, we show that the extracted factors capture meaningful real and nominal structures, while the ridge-regularized VAR delivers stable impulse responses and coherent short- and medium-term dynamics for variables central to the sovereign debt identity. A recursive out-of-sample evaluation indicates that the ridge-FAVAR systematically improves medium-term forecasting accuracy relative to standard AR benchmarks, particularly for real GDP growth and the interest–growth differential. The results highlight the usefulness of shrinkage-augmented factor models for macro–fiscal forecasting and motivate further econometric work on regularized state-space and structural factor VARs.

• Item Type: MPRA Paper
• Language: English
• Keywords: FAVAR, Ridge Regression, Forecasting, High-Dimensional Data, Fiscal Policy, Debt Dynamics, Macro–Fiscal Modelling
• Subjects: C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C32 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes ; State Space Models; C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C38 - Classification Methods ; Cluster Analysis ; Principal Components ; Factor Models; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C53 - Forecasting and Prediction Methods ; Simulation Methods; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C55 - Large Data Sets: Modeling and Analysis; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; H - Public Economics > H6 - National Budget, Deficit, and Debt > H63 - Debt ; Debt Management ; Sovereign Debt

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