A Comparison of the Forecasting Ability of ECM and VAR Models

Abstract

The results of forecasting experiments based on an error correction mechanism (ECM) model and various types of vector autoregressive (VAR) and Bayesian vector autoregressive (BVAR) models are presented. A Bayesian error correction mechanism (BECM) model is also tested. This model represents a hybrid of the BVAR and ECM models. The results from experiments using fifty industries and monthly Ohio labor market data demonstrate that the ECM model produces forecasts with much lower errors than any of the alternative VAR or BVAR models when the variables used in the model pass the statistical tests for cointegration. The findings confirm many of the beliefs expressed by Granger (1986) and Engle and Yoo (1987) based on theoretical consideration of the ECM model versus the VAR model. A result contradictory to the contentions of Engle and Yoo is that the BECM model performs well at the longer forecast horizons for both cointegrated and non-cointegrated industries.