The Error Term in the History of Time Series Econometrics

We argue that many methodological confusions in time-series econometrics may be seen as arising out of ambivalence or confusion about the error terms. Relationships between macroeconomic time series are inexact, and, inevitably, the early econometricians found that any estimated relationship would only fit with errors. Slutsky interpreted these errors as shocks that constitute the motive force behind business cycles. Frisch tried to dissect the errors further into two parts: stimuli, which are analogous to shocks, and nuisance aberrations. However, he failed to provide a statistical framework to make this distinction operational. Haavelmo, and subsequent researchers at the Cowles Commission, saw errors in equations as providing the statistical foundations for econometric models and required that they conform to a priori distributional assumptions specified in structural models of the general equilibrium type, later known as simultaneous-equations models. Because theoretical models were at that time mostly static, the structural modeling strategy relegated the dynamics in time-series data frequently to nuisance, atheoretical complications. Revival of the shock interpretation in theoretical models came about through the rational expectations movement and development of the vector autoregression modeling approach. The so-called London School of Economics dynamic specification approach decomposes the dynamics of the modeled variable into three parts: short-run shocks, disequilibrium shocks, and innovative residuals, with only the first two of these sustaining an economic interpretation.(This abstract was borrowed from another version of this item.)