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Error Correction Mechanisms


  • Salmon, Mark


The interface between economic theory and applied econometrics is often one of uneasy compromise, with the pragmatic justification for many accepted procedures resting on a theoretical base. This paper examines the surprisingly strong arguments that exist in terms of economic theory, for the use of error correction mechanisms in the specification of short run dynamic adjustment. A common heresy exists that while economic theory provides a detailed analysis of comparative static equilibria it can offer no guidance as to the appropriate specification of dynamic adjustment towards an equilibrium. perhaps in consequence it is not uncommon to find examples where the necessary dynamic specification is achieved by "tacking" onto an existing equilibrium specification some relatively ad hoc short run adjustment scheme. The intercession of stochastic arguments in this process is confused and critical implications are frequently ignored in practice, but perhaps more importantly there will typically be no guarantee that the dynamic specification is consistent with the prescribed equilibrium. Consistency in this sense requires that the short run dynamic adjustment be directed by the perceived disequilibrium and that eventual convergence to the equilibrium position be ensured. That two separate theoretical arguments, co-exist within the final specification is the root cause of many difficulties both theoretical and empirical.

Suggested Citation

  • Salmon, Mark, 1982. "Error Correction Mechanisms," The Warwick Economics Research Paper Series (TWERPS) 199, University of Warwick, Department of Economics.
  • Handle: RePEc:wrk:warwec:199

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    References listed on IDEAS

    1. Wilson, Charles A, 1979. "Anticipated Shocks and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 87(3), pages 639-647, June.
    2. Brock, William A., 1975. "A simple perfect foresight monetary model," Journal of Monetary Economics, Elsevier, vol. 1(2), pages 133-150, April.
    3. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-325, August.
    4. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-1311, July.
    5. Dornbusch, Rudiger & Fischer, Stanley, 1980. "Exchange Rates and the Current Account," American Economic Review, American Economic Association, vol. 70(5), pages 960-971, December.
    6. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    7. Flood, Robert P & Garber, Peter M, 1980. "Market Fundamentals versus Price-Level Bubbles: The First Tests," Journal of Political Economy, University of Chicago Press, vol. 88(4), pages 745-770, August.
    8. Olivier Jean Blanchard, 1980. "The Monetary Mechanism in the Light of Rational Expectations," NBER Chapters,in: Rational Expectations and Economic Policy, pages 75-116 National Bureau of Economic Research, Inc.
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