Abstract
This paper develops a two-step approach for constructing Taiwan's financial conditions index (FCI). In the first step, by employing the Panel Analysis of Nonstationarity in Idiosyncratic and Common components (PANIC) proposed by Bai and Ng (2004), we obtain six common factors to capture the price and quantity fluctuations in the stock market, the money market and the foreign exchange market. In the second step, we construct the FCI based on these factors, with their weights determined by the method of Deutsche Bank, and find the resulting signs of these weights are consistent with the implications of macroeconomic theories. Moreover, the results of Granger causality tests and the pseudo out-of-sample experiments suggest that the FCI developed in this paper can lead the dynamics of many macroeconomic variables. This property may be helpful for improving economic forecasts.