Error correction model: Difference between revisions

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An '''error correction model''' belongs to a category of multiple [[ time series]] models most commonly used for data where the underlying variables have a long-run stochastic trend, also known as [[cointegration]]. ECMs are a theoretically-driven approach useful for estimating both short-term and long-term effects of one time series on another. The term error-correction relates to the fact that last-periods deviation from a long-run equilibrium, the ''error'', influences its short-run dynamics. Thus ECMs directly estimate the speed at which a dependent variable returns to equilibrium after a change in other variables.

==History of ECM==

Yule(1936) and Granger and Newbold (1974) were the first to draw attention to the problem of [[spurious correlation]] and find solutions on how to address it in time series analysis. Given two completely unrelated but integrated (non-stationary) time series, the [[regression analysis]] of one on the other will tend to produce an apparently statistically significant relationship and thus a researcher might falsely believe to have found evidence of a true relationship between these variables. [[Ordinary least squares]] will no longer be consistent and commonly used test-statistics will be non-valid. In particular, [[Monte Carlo method| Monte Carlo simulations]] show that one will get a very high [[coefficient of determination| R squared]], very high individual [[t-statistic]] and a low [[Durbin–Watson statistic]]. Technically speaking, Phillips (1986) proved that parameter estimates will not [[Convergence in probability|converge in probability]], the [[Y-intercept| intercept]] will diverge and the slope will have a non-degenerate distribution as the sample size increases. However, there might a common [[cointegration |stochastic trend]] to both series that a researcher is genuinely interested in because it reflects a long-run relationship between these variables.

Because of the stochastic nature of the trend it is not possible to break up integrated series into a deterministic (predictable) [[trend stationary| trend]] and a stationary series containing deviations from trend. Even in deterministically detrended [[random walk| random walks]]s walks spurious correlations will eventually emerge. Thus detrending doesn't solve the estimation problem.

In order to still use the [[Box–Jenkins| Box–Jenkins approach]], one could difference the series and then estimate models such as [[ARIMA]], given that many commonly used time series (e.g. in economics) appear to be stationary in first differences. Forecasts from such a model will still reflect cycles and seasonality that are present in the data. However, any information about long-run adjustments that the data in levels may contain is omitted and longer term forecasts will be unreliable.

This lead [[John Denis Sargan|Sargan]] (1964) to develop the ECM methodology, which retains the level information.

==Estimation==

Several methods are known in the literature for estimating a refined dynamic model as described above. Among these are the Engel and Granger 2-step approach, estimating their ECM in one step and the vector-based VECM using [[Johansen test| Johansen's method]].

===Engel and Granger 2-Step Approach===

The first step of this method is to pretest the individual time series one uses in order to confirm that they are [[Stationary process|non-stationary]] in the first place. This can be done by standard [[unit root]] testing such as [[Augmented Dickey–Fuller test]].

Take the case of two different series <math>x_t</math> and <math>y_t</math>. If both are I(0), standard regression analysis will be valid. If they are integrated of a different order, e.g. one being I(1) and the other being I(0), one has to transform the model.

If they are both integrated to the same order (commonly I(1)), we can estimate an ECM model of the form: <math> A(L) \Delta y_t = \gamma + B(L)\Delta x_t + \alpha (y_t -\beta_0 - \beta_1 x_t ) + \nu_t </math>.

''If'' both variables are integrated and this ECM exists, they are cointegrated by the Engle-Granger representation theorem.

The second step is then to estimate the model using [[Ordinary least squares]]: <math> y_t = \beta_0 + \beta_1 x_t + \epsilon_t </math>

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Then the predicted residuals <math>\hat{\epsilon_t}= y_t -\beta_0 - \beta_1 x_t </math> from this regression are saved and used in a regression of differenced variables plus a lagged error term: <math> A(L) \Delta y_t = \gamma + B(L)\Delta x_t + \alpha \hat{\epsilon_t} + \nu_t </math>.

One can then test for cointegration using a standard [[t-statistic]] on <math>\alpha</math>.

While this approach is easy to apply, there are, however numerous problems:

<ul>

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===VECM===

The Engle-Granger approach as described above suffers from a number of weaknesses. Namely it is restricted to only a single equation with one variable designated as the dependent variable, explained by another variable that is assumed to be weakly exogeneous for the parameters of interest. It also relies on pretesting the time series to find out whether variables are I(0) or I(1). These weaknesses can be addressed through the use of Johansen's procedure. Its advantages include that pretesting is not necessary, there can be numerous cointegrating relationships, all variables are treated as endogenous and tests relating to the long-run parameters are possible. The resulting model is known as a vector error correction model (VECM), as it adds error correction features to a multi-factor model known as [[vector autoregression]] (VAR). The procedure is done as follows:

* Step 1: estimate an unrestricted VAR involving potentially non-stationary variables

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* {{cite book |last=Dolado |first=Juan J. |last2=Gonzalo |first2=Jesús |last3=Marmol |first3=Francesc |chapter=Cointegration |pages=634–654 |title=A Companion to Theoretical Econometrics |editor-first=Badi H. |editor-last=Baltagi |___location=Oxford |publisher=Blackwell |year=2001 |isbn=0-631-21254-X |doi=10.1002/9780470996249.ch31 }}

* {{cite book |first=Walter |last=Enders |title=Applied Econometric Time Series |edition=Third |___location=New York |publisher=John Wiley & Sons |year=2010 |isbn=978-0-470-50539-7 |pages=272–355 }}

*{{cite journal |last=Engle |first=Robert F. |last2=Granger |first2=Clive W. J. |year=1987 |title=Co-integration and error correction: Representation, estimation and testing |journal=[[Econometrica]] |volume=55 |issue=2 |pages=251–276 |jstor=1913236 }}</ref>

* {{cite journal |last=Granger |first=C.W.J. |first2=P.|last2=Newbold |year=1978 |title=Spurious regressions in Econometrics | volume=2| issue=2| journal=[[Journal of Econometrics 2]] |pages=111-120111–120 |jstor=2231972| url=http://EconPapers.repec.org/RePEc:eee:econom:v:2:y:1974:i:2:p:111-120 }}

* {{cite book |last=Lütkepohl |first=Helmut |authorlink=Helmut Lütkepohl |title=New Introduction to Multiple Time Series Analysis |___location=Berlin |publisher=Springer |edition= |year=2006 |isbn=978-3-540-26239-8 |pages=237–352 }}

* {{cite book |last=Martin |first=Vance |last2=Hurn |first2=Stan |last3=Harris |first3=David |title=Econometric Modelling with Time Series |___location=New York |publisher=Cambridge University Press |year=2013 |isbn=978-0-521-13981-6 |pages=662–711 }}

*{{cite journal|last1=Phillips|first1=Peter C.B.|title=Understanding Spurious Regressions in Econometrics|journal=Cowles Foundation Discussion Papers 757|date=1985|url=http://cowles.yale.edu/sites/default/files/files/pub/d07/d0757.pdf|publisher=Cowles Foundation for Research in Economics, Yale University}}

* Sargan, J. D. (1964). "Wages and Prices in the United Kingdom: A Study in Econometric Methodology", 16, 25–54. in ''Econometric Analysis for National Economic Planning'', ed. by P. E. Hart, G. Mills, and J. N. Whittaker. London: Butterworths

*{{cite journal|last1=Yule|first1=Georges Udny|title=Why do we sometimes get nonsense correlations between time series?- A study in sampling and the nature of time-series|journal=Journal of the Royal Statistical Society|date=1926|volume=89|issue=1|pagepages=1-631–63|jstor=2341482 }}

[[Category:Error detection and correction]]