Error Correction Mechanisms and Short-Run Expectations

Abstract

Reflecting the nature of economic decisions, the error correction mechanism (ECM) in the error-correction representation of a system of co-integrated variables may arise from forward-looking behavior. In such a case, the estimated ECM coefficients may misleadingly appear to be insignificant or to have the opposite-than-expected sign if the variables in the error-correction representation do not adequately capture short-run expectations. This paper explores the nature of this problem with a theoretical model for consumption and demonstrates how severe the problem can be with U.S. data. Because the conditions for similar erroneous inferences are likely to apply to many other settings, the paper also recommends a reexamination of the evidence in cases where the ECM appears to be insignificant or to display the "wrong" sign.

Keywords: error correction mechanism

JEL Classification: C22, C51, E21