CONSTANTS DO NOT STAY CONSTANT BECAUSE VARIABLES ARE VARYING Rasmus Kattai*   Working Papers of Eesti Pank No 1/2007

This paper focuses on the dynamic properties of error correction models (ECM). It is shown that the absence of structural breaks in the cointegrating vector does not necessarily imply that also all parameters of the dynamic specification of the ECM are time invariant. In some cases, depending on the data generating process of regressors, the intercept has to be time varying in order to have the long run equilibrium of a dynamic model independent of the growth rates of the variables out of sample period, i.e. to satisfy the dynamic homogeneity condition. It is found to be common when estimating ECMs on macroeconomic time series of converging countries. Dynamic homogeneity can be achieved by imposing the state dependent dynamic homogeneity restriction on the intercept. Applying the restriction is illustrated by an empirical example using Estonian data on real wages and labour productivity.
JEL Code: C32, C51
Key words: dynamic homogeneity, error correction models, forecasting

*  I am grateful to Aurelijus Dabušinskas (Eesti Pank), Mark Knell (NIFU STEP), Dmitry Kulikov (Eesti Pank), John Lewis (De Nederlandsche Bank), Ard H.J. den Reijer (De Nederlandsche Bank) and Karsten Staehr (Eesti Pank) for their useful comments and suggestions.
Comments made in the DNB's research seminar and in 62nd IAES conference are most acknowledged. The author takes the responsibility for any errors and/or omissions. The research is partially financed by the Estonian Science Foundation (ETF) grant project no. 6475.

Author's e-mail address: rkattai@epbe.ee

The views expressed are those of the author and do not necessarily represent the official views of Eesti Pank.

Contents

1. Introduction

2. Dynamic homogeneity condition

3. State dependent dynamic homogeneity restriction

4. Empirical application

5. Conclusions

References

Figures

Constants do not stay constant because variables are varying, Working Papers of Eesti Pank No 1/2007 (PDF*)

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