Equilibrium Correction Model Research Articles

Forecasting the UK top 1% income share in a shifting world

AbstractUK top income shares have varied hugely over the past two centuries, ranging from more than 30% to less than 7% of pre‐tax national income allocated to the top 1 percentile. We build a congruent dynamic linear regression model of the top 1% income share allowing for economic, political and social factors. Saturation estimation is used to model outliers and trend breaks, proxying underlying structural changes driving income inequality in the UK. We use the model to forecast the top 1% income share over the last 15 years, and compare to a range of forecast devices. Despite a well‐specified constant parameter model conditioning on significant explanatory variables, the best performing forecasts are obtained from a random walk and a smoothed random walk. These results are explained by the presence of shifts in the income share over the forecast period, resulting in forecasts from equilibrium correction models converging to the wrong equilibrium. Our best prediction for 2026 based on the most recent data from 2021 (a 5‐year ahead projection) is that the pre‐tax top 1% income share will remain at the most recent realized value of 12.7%, but there is a large degree of uncertainty, with a 95% confidence band ranging from 10% to 15.7%.

Can green finance be helpful in shifting from resource curse to resource blessing in China? Evidence from Markov switching equilibrium model

AbstractKeeping aside the debate over whether resources are a burden or a blessing, the resource curse theory has been put to the test in the literature using several significant variables. The “resource curse” concept does emphasize the need for green financing, but sadly, this was not taken into account. Recently, due to strong environmental pressure, the need for green financing has been acknowledged. Keeping this in mind, it is crucial to consider how green finance might improve the use of natural resources to stimulate economic growth. Therefore, in this work, we explore the role of green financing, innovation, and economic complexity in the theory of the resource curse. The study used a Markov switching equilibrium correction model with shifts for the data from 2000 to 2019 in a Chinese context. Due to the overuse of natural resources, empirical data support the presence of the resource curse theory in China. The study's findings also support the favorable effects of innovation, the economic complexity index, and green finance on economic performance. In order to turn China's resource curse into a resource blessing, the study directs policymakers, government officials, and scholars toward theoretical and practical implications related to green finance and innovation.

Cointegration Analysis of Triple Deficits: An Indicator Saturation Approach

The objective of this study to examine the econometric technique of the triple deficit’s hypothesis in the existence of multiple structural breaks. Triple deficit theory is a put forward by expanding the twin deficit theory, to recognize the private deficit together with the trade deficit and budget deficit and to investigate the relationship among these under the Keynesian approach. The annual time series data has been used from 1975 to 2020. This study has applied econometric techniques that captured the impact of multiple structural breaks in the series. In this study we used the saturation approach (impulse indicator saturation and step indicator saturation) for multiple structural breaks and equilibrium correction model (EqCM) for cointegration analysis. Results concluded that in the static equilibrium correction model there has been a positive relationship between fiscal-deficit, private deficit, and trade-deficit in the existence of multiple breakpoints. In the dynamic equilibrium correction model, there exists a positive relationship both in (short-term and long-term) between budget-deficit, private deficit, and trade deficit in the presence of three-step indicators. Therefore, to control the deficits government should make such type of policies that mitigates the effects of structural breaks, and this will atomically reduce the adverse effects of shocks to the trade sector and financial sector.

Bootstrap cointegration tests in ARDL models

The paper proposes a new bootstrap approach to Pesaran, Shin, and Smith’s bound tests in a conditional equilibrium correction model to overcome some typical drawbacks of the latter, such as inconclusive inference and distortion in size. The bootstrap tests are worked out under several data-generating processes, including degenerate cases. Monte Carlo simulations confirm the better performance of the bootstrap tests relative to bound ones and the asymptotic F test on the independent variables of the autoregressive distributed lag, or ARDL, model. Empirical applications highlight the importance of employing the appropriate specification and provide definitive answers to the inconclusive inference of the bound tests when exploring the long-term equilibrium relationship between economic variables.

How do green energy investment, economic policy uncertainty, and natural resources affect greenhouse gas emissions? A Markov-switching equilibrium approach

Energy efficiency has enormous potential for boosting economic development while simultaneously reducing greenhouse gas emissions. Energy efficiency improvements are widely accepted as a necessary corollary of China's decarbonisation efforts. This study analysed key factors in green energy investment and its determinants, i.e. natural resources and uncertainty of economic policy on greenhouse gas emissions, from 1987 to 2019. This work conduct a thorough empirical analysis and used innovative econometric techniques, such as the Markov-switching equilibrium correction model for long-run estimation and the kernel-based regularised least squares machine-learning approach, to establish the direction of causality for the variables in this study. The results indicate that green energy investment is significantly correlated with greenhouse gas emissions and helps to support environmental quality. However, although natural resources and economic policy uncertainty support economic growth, they are harmful to environmental quality. This conclusion implies that the Chinese government should exploit green energy investment to strengthen environmental performance as its long-term strategy.

Tax or Clean Technology? Measuring the True Effect on Carbon Emissions Mitigation for Sweden and Norway

Studies of carbon emissions typically focus on price and tax effects or technology. We argue that the two are closely linked within an economy in disequilibrium. Our goals are twofold: (1) to examine the combined role of: low CO2 technology, fuel taxes and CO2 tax on taming CO2 emissions and (2) to build a counterfactual analysis by capturing anything else that causes emissions to diverge from the trend such as renewable energy, energy laws and the state of the economy. The equilibrium correction model (EqCM) suggests that emissions have a long-term relationship with economic growth, fossil fuel use, taxes and clean power sources. Both oil and gas extraction and economic growth raise Norway’s emissions, offsetting the mitigating effect of taxes. Sweden´s carbon fuel tax elasticity is 20%, a value far above Norway´s elasticity, even though these carbon taxes were phased-in under a period of macroeconomic instability, weakening their effectiveness. The income elasticity of emissions is negative for Norway and positive for Sweden. Emission cuts require (a) de-growth, (b) a higher tax on transport fuels and (c) electrification of transport. The effects of tax, technology, economic growth and those for the pre- and post-carbon tax era differ strongly in the two nations.

Socio-economic impact assessment of environmental degradation in Pakistan: fresh evidence from the Markov switching equilibrium correction model

Socio-economic impact assessment of environmental degradation in Pakistan: fresh evidence from the Markov switching equilibrium correction model

Estimating the Long-run Equilibrium among Foreign Direct Investment, Foreign Portfolio Investment and Economic Growth: The Case of Indian Economy

Foreign institutional investment (FII) and foreign direct investment (FDI) play a vital role in the economic development of a country as these capital flows bridge the gap between the domestic savings and the amount required for achieving the targeted capital formation. This paper tries to study how these capital flows are helping India in enhancing the economic activities. It attempts to confirm the long-run and short-run relationship among the foreign direct investment, foreign institutional investments and Index of Industrial Production (IIP) in India during April, 2012 to March, 2020. Johansen cointegration test is applied to confirm the presence of long-run equilibrium and Vector Error Correction Model is applied to study the long-run and short-run properties of the variables. Finally, we have applied Impulse Response Function to understand the dynamic behaviour of the variables in the model.. It is found that the three variables- FDI, FII and IIP are cointegrated in the long-run. However, there is no causality running from FDI and FII to IIP as per the results of VECM Model.

Did OPEC change its behaviour after the November 2014 meeting?

We analyse the behaviour of OPEC as a group by formulating a theoretical model that encompasses the perfect competition model and various forms of the imperfect competition model. By confronting the theoretical model with quarterly data for the period from 1992 to 2013 within the context of a cointegrated vector autoregressive (CVAR) model, we find support for the imperfect competition hypothesis regarding the output decisions of OPEC. We also find that a dynamic equilibrium correction model with imperfect competition is stable in-sample. However, a forecasting exercise for the period from 2014 to 2018 reveals that the model breaks down following the November 2014 meeting at which OPEC decided to keep its supply unchanged despite the huge oil price drop in advance. The model systematically underpredicts OPEC production over the forecast period and by as much as 2.5 million barrels per day at the end of 2016. During 2018, however, the model forecasts OPEC production quite well. Our findings suggest that the behaviour of OPEC did indeed change significantly after the November 2014 meeting.

Dutch disease in the Norwegian agricultural sector

Applying and augmenting the theoretical framework of the Dutch disease, this paper investigates potential negative effects from the petroleum industry in Norway on agricultural profitability, and implicitly on food security due to the farmland abandonment effect. Two fundamental transmission channels of the oil price with an impact on agricultural profitability are analysed by vector equilibrium correction models: (1) The impact on producer prices, which affect input prices and then the costs of production; (2) The impact on food imports via the import-weighted exchange rate. A third channel is the wage differential in the respective sectors. Arguably, further consequences of low profitability and less farmland area are an increased pressure to become more efficient, which may result in increased use of antibiotics and increased depletion of soil. Therefore, due to the natural limits of boosting efficiency in biological systems and the farmland abandonment effect, Dutch disease in the agricultural sector is generally more serious than in the classical deindustrialisation case.

Modelling non-stationary ‘Big Data’

‘Fat big data’ characterise data sets that contain many more variables than observations. We discuss the use of both principal components analysis and equilibrium correction models to identify cointegrating relations that handle stochastic trends in non-stationary fat data. However, most time series are wide-sense non-stationary—induced by the joint occurrence of stochastic trends and distributional shifts—so we also handle the latter by saturation estimation. Seeking substantive relationships when there are vast numbers of potentially spurious connections cannot be achieved by merely choosing the best-fitting equation or trying hundreds of empirical fits and selecting a preferred one, perhaps contradicted by others that go unreported. Conversely, fat big data are useful if they help ensure that the data generation process is nested in the postulated model, and increase the power of specification and mis-specification tests without raising the chances of adventitious significance. We model the monthly UK unemployment rate, using both macroeconomic and Google Trends data, searching across 3000 explanatory variables, yet identify a parsimonious, statistically valid, and theoretically interpretable specification.

Response Surface Regressions for Critical Value Bounds and Approximate p‐values in Equilibrium Correction Models1

AbstractWe consider the popular ‘bounds test’ for the existence of a level relationship in conditional equilibrium correction models. By estimating response surface models based on about 95 billion simulatedF‐statistics and 57 billiont‐statistics, we improve upon and substantially extend the set of available critical values, covering the full range of possible sample sizes and lag orders, and allowing for any number of long‐run forcing variables. By computing approximateP‐values, we find that the bounds test can be easily oversized by more than 5 percentage points in small samples when using asymptotic critical values.

Effects of Basel III Higher Capital and Liquidity Requirements on Banking Sectors across the Main South East Asian Nations

This paper analyzes the cost impact of the Basel III higher capital and liquidity requirements on bank capital, lending spreads, and steady state output across the main Southeast Asian nations (ASEAN-5). We also investigate potential long-run economic benefit expressed as a gain in steady state output (GDP). By emphasizing the use of dynamic stochastic general equilibrium and vector error correction models, we find that ASEAN-5 banking sectors are comfortably capitalized and need no recapitalization by January 1st 2019 deadline when Basel III is fully enforced. The new Basel III rules are assumed to force ASEAN-5 banks to increase lending spreads to pass down a portion of increasing funding costs to bank customers. The impact of 1 percentage point rise in common equity Tier 1 ratio on lending spreads is analyzed; to meet the regulatory capital minima of 7% as of 2015, ASEAN-5 banks will have to increase lending spreads by 30 basis points on average; to meet 10.5% fully effective by January 2019, ASEAN-5 banks will have to increase average lending spreads by 68 basis points. In terms of economic benefits, the estimates of this study indicate that the projected economic benefits across ASEAN-5 outweigh the economic costs in the long-run.

The impact of energy consumption and economic development on Ecological Footprint and CO2 emissions: Evidence from a Markov Switching Equilibrium Correction Model

Reducing the impact of air pollution and global environmental degradation on human health and quality of life for Qatari citizens represents the most important objective of the Qatar National vision 2030. With respect to this vision, this study investigates the effects of economic growth, energy consumption, trade openness, urbanization and financial development on environmental degradation by using the Markov Switching Equilibrium Correction Model with shifts in both the intercept and income per capita slope for the period 1970–2015. Unlike existing studies and in addition to the CO2 emissions pollutant, this paper uses the total Ecological Footprint and Ecological Carbon Footprint as new proxies of environmental degradation.Empirical results show strong evidence for cointegration with Markov shifts. In particular, our results show that the non-control for breaks can hide the true relationship among variables. The results show also that when controlling for breaks the Environment Kuznets curve (EKC) hypothesis holds for the CO2 emissions and Ecological carbon Footprint pollutants and the U-shaped behavior holds for the total Ecological Footprint. Moreover, the results show that these two behaviors (EKC and U-shaped) are regime dependent. Regarding the other explanatory variables, the results show that trade openness and urbanization worsen Ecological Footprint. However, the electricity consumption and financial development are positively related to the Ecological Footprint and negatively related to Ecological Carbon Footprint and CO2 emissions. Finally, we found evidence for the growth hypothesis for both pollutants. Based on these results, a detailed economic, energy and environmental policy is proposed and discussed for the case of Qatar.

A half-century diversion of monetary policy? An empirical horse-race to identify the UK variable most likely to deliver the desired nominal GDP growth rate

The financial crisis of 2007–2008 triggered monetary policy designed to boost nominal demand, including ‘Quantitative Easing’, ‘Credit Easing’, ‘Forward Guidance’ and ‘Funding for Lending’. A key aim of these policies was to boost the quantity of bank credit to the non-financial corporate and household sectors. In the previous decades, however, policy-makers had not focused on bank credit. Indeed, over the past half century, different variables were raised to prominence in the quest to achieve desired nominal GDP outcomes. This paper conducts a long-overdue horse race between the various contenders in terms of their ability to account for observed nominal GDP growth, using a half-century of UK data since 1963. Employing the ‘General-to-Specific’ methodology, an equilibrium-correction model is estimated suggesting a long-run cointegrating relationship between disaggregated real economy credit and nominal GDP. Short-term and long-term interest rates and broad money do not appear to influence nominal GDP significantly. Vector autoregression and vector error correction modelling shows the real economy credit growth variable to be strongly exogenous to nominal GDP growth. Policy-makers are hence right to finally emphasise the role of bank credit, although they need to disaggregate it and specifically target bank credit for GDP-transactions.

The Nexus between Nigerian Government Spending and Domestic Output in the Presence of Long-Term Crude Oil Price Shock: A Conditional Unrestricted Equilibrium Correction Model Approach

This paper is an empirical analysis of provisional unrestricted level relationship between Nigerian domestic output measured by Gross Domestic Product (GDP) and government spending proxied by capital and recurrent expenditures in the presence of static regressors such as crude oil prices and federal government retained revenues. We estimate an ARDL (1,0,1) using a single-equation approach. Results show that government expenditures have negative but statistically insignificant effects on domestic output in the long-run. Similarly, negative short run effects are established amongst the variables. However, recurrent expenditure is statistically significant in the short-run. Whilst federal government retained revenue has a positive and significant effect, crude oil price exhibited negative relationships with domestic output both at level and in the short-run dynamics. Also a high speed of adjustment implies that Nigerian Gross Domestic Product is extremely sensitive to shocks on the government spending in the long-run. An upward trend forecast between 2014 and 2020 is an indication of the continued positive impact and the government retained revenue will exert on the domestic output in the long-run.

Geographical disaggregation of sectoral inflation. Econometric modelling of the Euro area and Spanish economies

ABSTRACTThis article studies the performance of different modelling strategies for 969 and 600 monthly price indexes disaggregated by sectors and geographical areas in Spain, regions and in the Euro Area 12 (EA12) countries. We also provide, by means of spatial bi-dimensional vector equilibrium correction models for all pairs of prices between neighbours, a description of spatial cointegration restrictions that could be useful for understanding price setting within an economy. We study the relevance of the regional disaggregation by using the proposed models to forecast the corresponding headline inflation and testing whether it is more accurate than alternative forecasts based on aggregated models. The results for Spain show that this is the case. Country disaggregation forecasts are also reliable for the EA12, but only because derived headline inflation forecasting is not significantly worse than alternative forecasts. The models in this article can be used for competitive analysis and other macro and regional analysis.

Identifying the sector bias of technical change

The empirical literature studying the sector bias of technical change has only focused on skill-biased technical change. In this paper, I analyse the sector bias of both factor-neutral and factor-biased technical change. In Norwegian data from 1972 to 2007, the empirical evidence is not clear on the impact of a sector bias of skill-biased technical change, but it points to a sector bias of factor-neutral technical change from the 1970s to the 1990s. That said, the impact of the sector bias seems to have reduced towards the latter part of the sample period. I also evaluate the cross-sectional model used in the literature and show the strong restrictions that must be placed on a vector equilibrium correction model to end up with the standard model. If these restrictions do not hold, the results reported in the literature may be biased. I show that the restrictions are strongly rejected, and that erroneously imposing them significantly changes the estimates of skill-biased technical change in many sectors. These results can, to some extent, be traced back to how the cross-sectional model ignores initial disequilibrium and imposes factors of production to be either complements or substitutes.

Robust approaches to forecasting

We investigate alternative robust approaches to forecasting, using a new class of robust devices, contrasted with equilibrium-correction models. Their forecasting properties are derived facing a range of likely empirical problems at the forecast origin, including measurement errors, impulses, omitted variables, unanticipated location shifts and incorrectly included variables that experience a shift. We derive the resulting forecast biases and error variances, and indicate when the methods are likely to perform well. The robust methods are applied to forecasting US GDP using autoregressive models, and also to autoregressive models with factors extracted from a large dataset of macroeconomic variables. We consider forecasting performance over the Great Recession, and over an earlier more quiescent period.

Macroeconomic Stability or Cycles? The Role of the Wage‐Price Spiral

We formulate a small and stylised dynamic macroeconomic model, and study how different specifications of the supply side affect the model's dynamic properties. The wage‐price equilibrium‐correction model (ECM) and the Phillips curve model (PCM) that both can be used to represent the supply side of a New Keynesian macro model, are synthesised in a generalised model of the wage‐price spiral. We show that the choice of ECM or PCM has implications for the long‐run stability of the macro model, without need of a NAIRU. We also find that the range of theoretically admissible dynamics is wide. For example, both the ECM and PCM may display endogenous cyclical fluctuations in inflation and unemployment, showing that even simple structures can give rise to complex dynamics. In practice that may entail that forecasting the effects of shocks and policy changes is difficult even in the best of circumstances.