1. 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
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Available in LSE Learning Resources Online: May 2012
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2. 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

3. 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

4. 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

5. 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

6. 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

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

8. Copyright Christopher Dougherty 2011.
These slideshows may be downloaded by anyone, anywhere for personal use.
Subject to respect for copyright and, where appropriate, attribution, they may be used as a resource for teaching an econometrics course. There is no need to refer to the author.
The content of this slideshow comes from Section 11.4 of C. Dougherty, Introduction to Econometrics, fourth edition 2011, Oxford University Press.
Additional (free) resources for both students and instructors may be downloaded from the OUP Online Resource Centre
Individuals studying econometrics on their own and who feel that they might benefit from participation in a formal course should consider the London School of Economics summer school course
EC212 Introduction to Econometrics
or the University of London International Programmes distance learning course
20 Elements of Econometrics