In econometrics, a dynamic factor (also known as a diffusion index) is a series which measures the co-movement of many time series. It is used in certain macroeconomic models.

A diffusion index is intended to indicate

• the changes of the fraction of economic data time series which increase or decrease over the selected time interval,

• an increase or decrease in future economic activity,

• provide some correlation to the business sentiment of companies.

Formally

is the vector of lagged factors of the variables matrix is the factor error.

History

Diffusion indexes were originally designed to help identify business cycle turning points.

Example

works out to be the percentage of these employment counts that increased in the previous month. Some researchers have reported that a diffusion index of monthly manufacturing-sector employment is a leading indicator of turning points in the business cycle.

References

Literature

• Forni, Mario & Lippi, Marco, 2001. "The Generalized Dynamic Factor Model: Representation Theory", Econometric Theory, vol. 17(6), pages 1113-41.

• Getz, Patricia M. and Mark Ulmer. "Diffusion indexes: an economic barometer", Monthly Labor Review, April 1990, Vol. 113, No. 4, pp.13–22.

• Stock, James H & Watson, Mark W, 2002. "Macroeconomic Forecasting Using Diffusion Indexes", Journal of Business & Economic Statistics, vol. 20(2), pages 147-62.