Equilibrium Correction Model Research Articles

Exchange Rate Pass-through to Import Prices, and Monetary Policy in South Africa

Understanding how import prices adjust to exchange rates helps anticipate inflation effects and monetary policy responses. This article examines exchange rate pass-through to the monthly import price index in South Africa during 1980–2009. Short-horizon pass-through estimates are calculated using both single equation equilibrium correction models and systems (Johansen) models, controlling for both domestic and foreign costs. Average pass-through is incomplete at about 50 per cent within a year and 30 per cent in six months, and in the long-run, from the Johansen analysis including feedback effects, is about 55 per cent. There is evidence of slower pass-through under inflation targeting; pass-through is found to decline with recent exchange rate volatility and there is evidence for asymmetry, with greater pass-through occurring for small appreciations.

Learning and Trusting Cointegration in Statistical Arbitrage

This technical paper offers simple views and uses of cointegration analysis which are not often clear in textbook presentation and research literature. Decompositions of time series and derivations, usually omitted in presentation of the equilibrium correction models, are collected in a structured Appendix A. Instead of constructing a long-term forecast and entering what essentially is a trend-following strategy, the experienced arbitrageur would use the mean-reversion feature of the highly autoregressive spread generated by a cointegrated relationship. The suitability of mean-reversion is evaluated by fitting the spread to the Ornstein–Uhlenbeck process that provides a balanced fit for the features of correction to the long-term equilibrium. Conclusions formulate and address three common complaints about economic tests for cointegration and instability of the equilibrium.

Self-reinforcing effects between housing prices and credit

The financial crisis has brought the interaction between housing prices and household borrowing into the limelight of the economic policy debate. This paper examines the nexus of housing prices and credit in Norway within a structural vector equilibrium correction model (SVECM) over the period 1986q2–2008q4. The results establish a two way interaction in the long-run, so that higher housing prices lead to a credit expansion, which in turn puts an upward pressure on prices. Interest rates influence housing prices indirectly through the credit channel. Furthermore, households’ expectations about the future development of their own income as well as in the Norwegian economy have a significant impact on housing price growth. Dynamic simulations show how shocks are propagated and amplified. When we augment the model to include the supply side of the housing market, these effects are dampened.

Performance prediction of fluidised bed gasification of biomass using experimental data-based simulation models

Wood sawdust is gasified in air-fluidized bed with steam injection for the enrichment of product gas with hydrogen. A gasification experimental setup with sand as bed material is designed and developed for this purpose with a biomass feed rate of 10.3 kg/h. Air and steam flow rates are varied between 0.0042–0.0063 and 0–0.0072 m3/h, respectively. Axial variations of temperature and pressure inside the reactor shell are investigated. The data for the product gas composition from the experiment are utilised to develop two models. One is a feedforward artificial neural network (ANN) model for the prediction of gasification temperature and product gas composition. The second is a Redlich–Kwong real gas equilibrium correction model incorporating tar (aromatic hydrocarbons) and unconverted char to predict the product gas composition, heating value and thermodynamic efficiencies. Good accuracy of ANN prediction with experimental results is achieved based on the computed statistical parameters of comparison such as coefficient of correlation, root mean square error (RMSE), average percentage error and covariance. The corrected equilibrium model developed by introducing correction factors for real gas equilibrium constants shows satisfactory agreement (RMSE = 5.96) with the experimental values. Maximum concentration of hydrogen achieved in the experiments is 29.1 % at the equivalence ratio (ER) = 0.277 and steam to biomass ratio (SBR) = 2.53. The corresponding predicted values are 28.2 % for ANN model and 31.6 % for corrected equilibrium model. The corrected equilibrium model for wood sawdust is validated with major air–steam gasification experimental results of other biomass materials and is found to be 95.1 % accurate on average. It is revealed from the study that the ANN model (RMSE = 2.64) is a better predictor for the product gas composition than the corrected real gas equilibrium model (RMSE = 5.96). The study proposes a more comprehensive ANN model capable of simulating various process conditions in fluidised bed gasification applicable to variety of biomass feedstocks.

The determinants of aggregate creditors’ voluntary liquidations

This article investigates the determinants of Creditors’ Voluntary Liquidations (CVLs), an area of research that has received comparatively scant attention in the literature despite the fact that, at least in the UK, this form of insolvency has consistently comprised the majority of company failures. It develops an Equilibrium Correction Model (ECM) to explain variations in the aggregate number of CVLs in England and Wales between 1963 and 1995. This is then subjected to out-of-sample testing over the subsequent 10-year period. The results indicate that in both the short-run and the long-run, changes in the level of liquidations can be explained by two main explanatory variables namely: the nominal after-tax cost of borrowing and changes in the overall level of economic activity. In addition, confirmatory evidence is provided for the dampening effect of the 1986 Insolvency Act on the number of liquidations. The model retains its forecasting accuracy in the out-of-sample period although there is possibly some preliminary evidence of a further mitigating effect associated with the Enterprise Act 2002.

Effects of Monetary Policy on the US Dollar/UK Pound Exchange Rate. Is There a “Delayed Overshooting Puzzle”?

AbstractThe determination of the US dollar/UK pound sterling exchange rate is studied in a small symmetric macroeconometric model including UK–US differentials in inflation, output gap, and short‐ and long‐term interest rates for the four decades since the breakdown of Bretton Woods. The key question addressed is the possible presence of a “delayed overshooting puzzle” in the dynamic reaction of the exchange rate to monetary policy shocks. In contrast to the existing literature, we follow a data‐driven modeling approach combining (i) a vector autoregression (VAR)‐based cointegration analysis with (ii) a graph‐theoretic search for instantaneous causal relations and (iii) an automatic general‐to‐specific approach for the selection of a congruent parsimonious structural vector equilibrium correction model. We find that the long‐run properties of the system are characterized by four cointegration relations and one stochastic trend, which is identified as the long‐term interest rate differential and that appears to be driven by long‐term inflation expectations as in the Fisher hypothesis. It cointegrates with the inflation differential to a stationary “real” long‐term rate differential and also drives the exchange rate. The short‐run dynamics are characterized by a direct link from the short‐term to the long‐term interest rate differential. Jumps in the exchange rate after short‐term interest rate variations are only significant at 10%. Overall, we find strong evidence for delayed overshooting and violations of uncovered interest rate parity (UIP) in response to monetary policy shocks.

Improving forecasting in an emerging economy, South Africa: Changing trends, long run restrictions and disaggregation

Abstract Forecasting inflation is particularly challenging in emerging markets, where trade and monetary policy regimes have shifted and the exchange rate and food prices are highly volatile. This study shows that the information in long-run co-integrated relationships for relative prices in South Africa is helpful in outperforming univariate benchmark models for forecasting inflation. It also investigates gains to the inflation forecast accuracy as a result of aggregating weighted forecasts of the sub-component price indices, versus forecasting the aggregate consumer price index itself. Rich multivariate equilibrium correction models employ general and sectoral information for ten sub-components, including structural breaks and institutional changes. Model selection over the period 1979–2003 generates pseudo out-of-sample forecasts, four quarters ahead, until 2007. The largest gain in forecast accuracy against naive benchmark models comes from incorporating equilibrium correction into the long-run. For more sophisticated models, aggregating the weighted forecasts of the sub-components outperforms the aggregate forecasts. The analysis also contributes to an improved understanding of sectoral inflationary pressures.

Forecasting a monetary aggregate under instability: Argentina after 2001

This paper compares different forecasting approaches for the Argentine monetary aggregate M2, which is a key variable for monetary policy. First, we estimate a conditional equilibrium-correction model of money demand, which is theory consistent and accounts for the main features of the data. Next, we compare its forecasts with those obtained by other methods: a VAR in differences, naïve models, robustified devices, forecasting aggregates using disaggregates, and pooling of forecasts using different models and windows. They are evaluated over an unstable period in which there was often uncertainty about the economic regime. For forecasting the growth rate of M2, it can be useful to complement the equilibrium-correction model with other approaches like univariate AR models, either individually or by pooling.

Price-wage nexus and the role of a tax system

The presented study was aimed to test empirically major economic hypotheses dealing with long-term relationships between wages, producer prices, prices of consumer goods and services, the consumer price index, productivity of labour, unemployment and payroll expenses other than wages themselves. It is particularly important for this approach to distinguish between net wages shaping employees’ decisions and gross wages driving employers’ decisions. Because the variables are generated by non-stationary stochastic processes integrated of order 1 and 2, the analytical tool applied was a vector equilibrium correction model, VEqCM. The findings demonstrate that prices and payroll expenses are the major sources of shocks in the system in question. Wages and prices (particularly producer prices) are the most sensitive to this type of stochastic trends. In the Polish economy prices are integrated of order two, so they can be effectively influenced by anti-inflationary policy.

Modeling Money (M2) Demand in Egypt - A Vector Equilibrium Correction Model

This paper empirically investigates the relationship between real money demand, real income, interest rates and real consumption. The paper provide a mixed strategy for estimating the money demand function that incorporates shifting from a system of equations vector auto regression (VAR) approach that maintains the information relating to the feedback between variables, followed by vector equilibrium correction model (VECM) in order to investigate the nature of short term and long term interaction and finaly an error correction model (ECM) and autoregressive distributed lag model (ADL). The paper concludes that real money demand in Egypt is stable and can be confidently considered by monetary authorities to adjust for long run growth in the real economy.

Revisiting UK consumers’ expenditure: cointegration, breaks and robust forecasts

We revisit equilibrium-correction modelling of aggregate real consumers’ expenditure in the UK, using Autometrics applied to the data in Davidson, Hendry, Srba and Yeo (DHSY; 1978). The many selection decisions involved in developing viable empirical models are discussed in a setting where there are more candidate explanatory variables than observations, here due to Impulse-Indicator Saturation (IIS) for detecting breaks, outliers and data contamination. Additional tests of the selected model include whether it encompasses the original specification, evidence of nonlinearity and if the conditioning variables are super exogenous. We consider how IIS affects economic interpretations of models, and conversely, and the implications of robust forecasting devices.

An empirical model for Japan’s business fixed investment

Abstract This paper estimates a dynamic empirical model for Japan’s business fixed investment. A multivariate cointegration analysis of Japan’s time series data over the past two decades shows that the term spread (the difference between long-term and short-term interest rates) and various diffusion indices in the Bank of Japan’s business survey tend to synchronise with fixed investment. The term spread and diffusion indices are then all judged to be not only weakly exogenous but also super exogenous for parameters of interest. Thus, a single-equation equilibrium correction model for fixed investment is estimated with no loss of information and can be used for policy analysis. The equilibrium correction model sheds useful light on economic policies aimed at achieving stable investment growth in Japan.

The relationship between height and economic development in Spain, 1850–1958

We investigate the relationship between height and some economic-development indicators in modern Spain by means of a recently constructed times series of data on conscripts. We estimate a Vector Autoregressive Equilibrium Correction Model (VECqM) to quantify the height and GDP per capita response to various living-standard indicators. We observe that conditions that perpetuate an elevated level of sickness and mortality and that raise the relative price of consumption goods tend to impede human growth, as reflected in a decline in average adult height, whereas factors that promote the purchase of health services and that help to open up the economy to international trade and ideas have tended to have an opposite effect from the 1850s onward. Our results also indicate that neither the level of per capita GDP nor its growth rate has a unidirectional relation to various measures of living standards, chiefly adult stature. Instead, our findings suggest that there may be behavioral factors (e.g., emphasis on health services), political factors (e.g., degree of openness), and economic factors (e.g., relative consumer costs to GDP deflator) whose affects may have been influenced the level of GDP, over the sample period.

Forecasting with equilibrium-correction models during structural breaks

When location shifts occur, cointegration-based equilibrium-correction models (EqCMs) face forecasting problems. We consider alleviating such forecast failure by updating, intercept corrections, differencing, and estimating the future progress of an ‘internal’ break. Updating leads to a loss of cointegration when an EqCM suffers an equilibrium-mean shift, but helps when collinearities are changed by an ‘external’ break with the EqCM staying constant. Both mechanistic corrections help compared to retaining a pre-break estimated model, but an estimated model of the break process could outperform. We apply the approaches to EqCMs for UK M1, compared with updating a learning function as the break evolves.

Is there a cointegrating relationship between Australia's fossil-fuel based carbon dioxide emissions per capita and her GDP per capita?

Carbon dioxide (CO2) emission per capita of Australia, a high-income economy with a fossil fuel-rich fuel-mix, is proven to have a strong cointegrating relationship with her gross domestic product (GDP) per capita. A conditional equilibrium correction model (ECM) has been developed to quantify the relationship between the two variables by employing the autoregressive distributed lag bound-testing approach to cointegration. ECM reveals that 1% growth in Australia's GDP per capita induces 0.7% growth in her CO2 emission per capita in the long-run. The short-run dynamics are such that 1% growth in the previous year's GDP per capita leads to about 0.33% growth in current year's CO2 emission per capita. Moreover, any deviation from the long-run equilibrium is corrected in about two years and nine months. The conditional ECM developed is robust against functional form misspecification and have stable regression coefficients over the sample period studied. Thus, it could be used to reliably predict the future CO2 emissions in Australia. [Received: July 15, 2009; Accepted: December 17, 2009].

In memory of Clive Granger: an advisory board member of the journal

In memory of Clive Granger: an advisory board member of the journal

Forecasting Spanish Inflation Using the Maximum Disaggregation Level by Sectors and Geographical Areas

This article evaluates different strategies for forecasting Spanish inflation using information from price series for fifty-seven products and eighteen regions in Spain. We consider vector equilibrium correction (VeqCM) models that include cointegration relationships between Spanish prices and prices in the regions of Valencia, Andalusia, Madrid, Catalonia, and the Basque Country. This approach is consistent with economic intuition and is shown to be of tangible importance after suitable econometric evaluation. It is found that sectoral disaggregate models are useful for forecasting inflation in the five largest Spanish regions. Moreover, aggregate inflation forecasts in Spain can be significantly improved by aggregating projections from different sectors and geographical areas and by considering cointegration relationships between regional and national prices. However, in spite of the existence of long-run relationships between sectoral and national prices, they include deterministic components that are not consistent with the law of one price.

A STOCHASTIC ESTIMATION FRAMEWORK FOR COMPONENTS OF THE SOUTH AFRICAN CONSUMER PRICE INDEX

AbstractUnder inflation targeting in South Africa, it is important to monitor and forecast changes in prices, not only for aggregate measures of the consumer price index, but also its underlying sub‐components. Hypotheses about sectoral transmission of policy and shocks are often more specific than hypotheses about overall transmission. This study employs a stochastic framework to estimate richly specified equilibrium correction models, four‐quarters‐ahead, for the 10 sub‐components of the first targeted measure of the consumer price index, CPIX. The stochastic trends are estimated by the Kalman filter, and interpreted as capturing structural breaks and institutional change, a frequent cause of forecast failure. The trends suggest the design of deterministic split trends for use in recursive forecasting models, towards more accurate overall inflation forecasting. This research also has practical use for monetary policy in allowing identification of sectoral sources of inflation.

Physical market determinants of the price of crude oil and the market premium

We analyze the determinants of the real price of crude oil by means of an equilibrium correction model over the last two decades where we focus on the aspects of the physical market that impact on the clearing price. We find that two cointegrating relations affect the changes in prices: one refers to OPEC's behavior, attempting to control prices using its market power and quotas; the other to the coverage rate of OECD expected future demand using inventory behaviors. We derive a forecasting equation for the change in oil prices which we use to assess the speculative elements of the price increases of the period 2000–05. We show that worries alien to the physical markets were the causes of the increase in oil prices and we quantify their overall impact.

Market Reforms and Growth in Post-Socialist Economies: Evidence from Panel Cointegration and Equilibrium Correction Model

In this paper the impact of market reforms on economic growth has been analyzed using the panel data for 26 post-socialist economies over the period between 1989 and 2005. Taking into account the dynamic properties of the data, the concepts of cointegration and equilibrium correction model for panel data has been used as the analytical framework. First, well-specified regression models have been obtained. Second, long and short run aspects of 'reforms-growth' relationship have been considered. Out analysis has detected the existence of cointegration between the level of ERBD reform index and the level of real GDP per capita. This is interpreted as the presence of the long run relationship between these indicators. Third, it has been found that there is a statistically significant positive influence of economic reforms on economic growth in the long run. In addition, market reforms positively influence economic growth in the short-run, but with a one-year lag. The equilibrium correction mechanism in corresponding regressions reflects existing biases of the analyzed indicators from the equilibrium trajectory, as well as direction and speed of adjustment to this trajectory. Our approach to modeling of the relationship between market reforms and economic growth explains a puzzle of high rates of economic growth in some countries with a relatively low level of ERBD reform index. Finally, in contrast to other studies employing a different methodology, statistically significant influence of economic growth on market reforms has been established both in the long and short run, our study shows that there is no such relationship.