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Forecasting with Equilibrium-correction Models during Structural Breaks

  • Jennifer Castle
  • David Hendry
  • Nicholas W.P. Fawcett

When breaks occur, equilibrium-correction models (EqCMs) based on cointegration face forecasting problems.� We investigate approaches to alleviate forecast failure following a location shift, including updating, intercept corrections, differencing, and estimating the future impact of an 'internal' break during its progress.� Although updating can lead to a loss of cointegration when an EqCM suffers an equilibrium-mean shift, we show that updating can help when collinearities are changed by an 'external' break and the EqCM itself remains constant.� Both mechanistic corrections help compared to just retaining a pre-break estimated model, but an estimated model of the break process could outperform.� Throughout, we apply the approaches to the much-studied example of EqCMs for UK M1, and compare with updating a learning function as the break evolves.

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Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 408.

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Date of creation: 01 Oct 2008
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Handle: RePEc:oxf:wpaper:408
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  1. H. Peter Boswijk & Jurgen Doornik, 2003. "Identifying, Estimating and Testing Restricted Cointegrated Systems: An Overview," Economics Papers 2003-W10, Economics Group, Nuffield College, University of Oxford.
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  10. Clements, Michael P. & Hendry, David F., 2006. "Forecasting with Breaks," Handbook of Economic Forecasting, Elsevier.
  11. David Hendry & Carlos Santos, 2003. "Regression Models with Data-based Indicator Variables," Economics Series Working Papers 2004-W04, University of Oxford, Department of Economics.
  12. Hendry, David F., 2000. "On detectable and non-detectable structural change," Structural Change and Economic Dynamics, Elsevier, vol. 11(1-2), pages 45-65, July.
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  14. Hendry, David F., 2006. "Robustifying forecasts from equilibrium-correction systems," Journal of Econometrics, Elsevier, vol. 135(1-2), pages 399-426.
  15. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March.
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