Abstract
This paper derives a method for estimating and testing the Linear Quadratic Adjustment Cost (LQAC) model when the target variable and some of the forcing variables follow I(2) processes. Based on a forward-looking error-correction formulation of the model it is shown how to obtain strongly consistent estimates of the structural long-run parameters and the adjustment cost parameter from both a linear and a non-linear cointegrating regression, where first-differences of the I(2) variables are included as regressors (multicointegration). Further, based on the estimated parameter values, it is shown how to test and evaluate the LQAC model using a VAR approach. In an empirical application using UK money demand data, the non-linear multi-cointegrating regression delivers an economically plausible estimate of the adjustment cost parameter. However, the exact restrictions implied by the LQAC model under rational expectations are strongly rejected.
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