Partial Adjustment Model

The partial adjustment model comprises two parts, a static part to describe how the
desired amount is determined and the dynamic partial adjustment process:
y t* 0 1 xt u t
y t y t 1 ( y t* y t 1 )

Where y* is the desired level of y. By substituting the expression for y* into the other
equation we obtain the following estimating equation:
yt 0 (1 ) yt 1 1 xt u t

We can estimate this equation as a general ARDL model as follows:

y t 0 1 yt 1 2 xt 3 xt 1 vt

In this case the following restriction would be imposed if partial adjustment occurred:
3 0

In addition we could get estimates of the parameters in the original equation

containing the desired level of y, as well as the adjustment parameter . In the above
case:
1 (1 ) (1 1 )
2 1
0 0

The adjustment parameter measures the speed of adjustment and lies between 0 and
1. The closer it is to 1 the faster the speed of adjustment. An example of this model is
the Lintner Dividend-Adjustment Model.
The Error Correction Model
The error correction model (ECM) is an example of a short-run dynamic model,
which is used to model both economic and financial time series. It is expressed in first
differences ( y t yt yt 1 ), except the error correction term. It is based on the
ARDL model again and can be derived from this model, with the addition of a
specific restriction.
y t 0 1 yt 1 2 xt 3 xt 1 vt

To produce the ECM, firstly you have to subtract yt-1 from both sides of the ARDL
equation:
y t y t 1 y t 0 1 y t 1 2 xt 3 xt 1 y t 1 vt

The next step is to express the x in difference form. This involves adding and
subtracting 2 xt 1 from the right hand side of the above equation.
y t 0 1 y t 1 2 xt 2 xt 1 3 xt 1 y t 1 2 xt 1 vt

Collecting terms gives:

y t 0 2 xt ( 1 1) y t 1 ( 2 3 ) xt 1 vt

In order to produce the ECM, we need to assume that the coefficient on yt-1 is equal to
minus the coefficient on xt-1. That means:
1 1 ( 2 3 )
1 2 3 1

The sum of the coefficients, excluding the constant, must sum to one in the ARDL
model, for the ECM to apply. The ECM is usually written with as the coefficient on
the error correction term, to give the following:
yt 0 2 xt ( yt 1 xt 1 ) ut

( 1 1) ( 2 3 )

The above ECM is the short-run relationship between y and x. The long-run
relationship can be formed in the usual way, although instead of assuming all
differenced terms equal 0, we assume that they grow at a constant rate g. This gives:
g 0 2 g ( y * x*)

( y * x*) 0 ( 2 1) g
( 2 1) g
y* 0
x*

If the original model was:

y *t kx *t which

in logs is

log y *t log k log x *t .

Then in terms of the above long-run expression, when antilogged:

k exp[

0 ( 2 1) g
]

The term k can be interpreted as the long-run relationship between y and x. i.e. if y is
consumption and x is wealth, k would be the average propensity to consume from
wealth.