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Contents

Abstract

1 Introduction

2 Principles related to the selection of the indicator variables
2.1 Description of data
2.2 Choice of indicator variables and thresholds

3 Statistical behaviour of the selected macroeconomic variables
3.1 Stylised facts related to credit booms
3.2 Stylised facts related to instability episodes
3.3 Country specific patierns of the selected variables

4 Description of the Early Warning System (EWS) Approach
4.1 The signalling approach

5 Results
5.1 Performance of individual indicators
5.2 The combination of indicators
5.3 Lessons learnt from the results

6 Monetary policy implications

7 Conclusions

References
Appendix A Data availability
Appendix B Loss, usefulness and relative usefulness with different theta values
Appendix C Robustness check

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Abstract

In this paper we apply the Early Warning System methodology to ten Central and Eastern European Countries to find useful sets of indicators which could predict macroeconomic and financial imbalances. We argue that finding such indicators is crucial in the current monetary policy framework because significant imbalances could build up without any sign of risk to price stability. We examine the stylised behaviour of the most important macroeconomic variables over the business cycle and select the most preferred indicator variables. Our methodology consists of choosing the most useful combination of variables in terms of false alarms and misses, taken as given the preferences of the decision maker in terms of commiting various types of errors. We find, that a certain combination of the global financial variable, the real exchange rate, capital flows and credit is a plausible signal macroeconomic imbalances. The results suggest that although the above indicators should not be used mechanically, they could usefully complement analytical tools available to modern central banks.

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