Abstract

Building on an extension of the Gordon (1962) growth model we propose a simple approach to forecasting real growth, inflation and real exchange rate. This extension is rooted in introducing the Fisher (1930) and Euler equations, and in the open economy context, also the purchasing power parity (PPP) and the uncovered interest rate parity (UIP) relations to the analysis. These equilibrium conditions suggest a forecasting system of three simple equations, all based on current financial market information in the form of dividend yields and short-term interest rate. Our empirical results indicate that the role of simple financial market information both in the forms of dividend yields and nominal interest rate is relevant for forecasting out-of-sample the time-varying underlying trends in the macroeconomic data for the U.K., Euro-zone and Japan, when treating the U.S. as the world market. Our results strongly stress the importance of including some measure of stock market performance in macroeconomic forecasting systems, especially during turbulent time periods in financial markets and macro economy.