 # EC220 - Introduction to econometrics (chapter 11)

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EC220 - Introduction to econometrics (chapter 11)
Christopher Dougherty EC220 - Introduction to econometrics (chapter 11) Slideshow: the error correction model Original citation: Dougherty, C. (2012) EC220 - Introduction to econometrics (chapter 11). [Teaching Resource] © 2012 The Author This version available at: Available in LSE Learning Resources Online: May 2012 This work is licensed under a Creative Commons Attribution-ShareAlike 3.0 License. This license allows the user to remix, tweak, and build upon the work even for commercial purposes, as long as the user credits the author and licenses their new creations under the identical terms.

THE ERROR CORRECTION MODEL
The error correction model is a variant of the partial adjustment model. As with the partial adjustment model, we assume a long-run relationship between Y and X as shown, where Yt*is the level of Y that would correspond to the level of Xt in a long-run relationship. 1

THE ERROR CORRECTION MODEL
In the short run, DYt, the change in Yt from Yt–1, is determined by two components: a partial closing of the discrepancy between its previous appropriate and actual values, Y*t–1 – Yt–1, and a straightforward response to the rate of change in X, DXt. 2

THE ERROR CORRECTION MODEL
Hence we have a specification in which Yt is determined by Xt, Yt–1, and Xt–1, with the definitions of the new parameters as shown. 3

THE ERROR CORRECTION MODEL
d = b2 is the short-run effect of X on Y, and l = 1 – b3 is the speed of adjustment relating to the discrepancy. 4

THE ERROR CORRECTION MODEL
In this form, it is an ADL(1,1) model since it includes Xt–1 as an explanatory variable. The ADL(1,0) model is a special case with the testable restriction b4 = lg2 – d = 0. 5

THE ERROR CORRECTION MODEL
This way of representing the process will be particularly useful when we come to cointegration in Chapter 13. 6