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Paper No. 17-06

Download 17-06

Author: Steel MFJ

Title: Model Averaging and its Use in Economics

Abstract: The method of model averaging has become an important tool to deal with model uncertainty, in particular in empirical settings with large numbers of potential models and relatively limited numbers of observations, as are common in economics. Model averaging is a natural response to model uncertainty in a Bayesian framework, so most of the paper deals with Bayesian model averaging. In addition, frequentist model averaging methods are also discussed. Numerical methods to implement these methods are explained, and I point the reader to some freely available computational resources. The main focus is on the problem of variable selection in linear regression models, but the paper also discusses other, more challenging, settings. Some of the applied literature is reviewed with particular emphasis on applications in economics. The role of the prior assumptions in Bayesian procedures is highlighted, and some recommendations for applied users are provided (JEL: C11, C15, C20, C52, O47).