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Original Title: Partial Adjustment Model

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The partial adjustment model comprises two parts, a static part to describe how the

desired amount is determined and the dynamic partial adjustment process:

) (

1

*

1

1 0

*

=

+ + =

t t t t

t t t

y y y y

u x y

Where y* is the desired level of y !y substitutin" the e#pression for y* into the other

e$uation we obtain the followin" estimatin" e$uation:

t t t t

u x y y + + + =

1 1 0

) 1 (

We can estimate this e$uation as a "eneral %&'( model as follows:

t t t t t

v x x y y + + + + =

1 ) * 1 1 0

+n this case the followin" restriction would be imposed if partial adjustment occurred:

0

)

=

+n addition we could "et estimates of the parameters in the ori"inal e$uation

containin" the desired level of y, as well as the adjustment parameter , +n the above

case:

0 0

1 *

1 1

) 1 ( ) 1 (

=

=

= =

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 %n e#ample of this model is

the (intner 'ividend-%djustment .odel

The Error Correction Model

The error correction model (/0.) is an e#ample of a short-run dynamic model,

which is used to model both economic and financial time series +t is e#pressed in first

differences (

1

=

t t t

y y y

), e#cept the error correction term +t is based on the

%&'( model a"ain and can be derived from this model, with the addition of a

specific restriction

t t t t t

v x x y y + + + + =

1 ) * 1 1 0

To produce the /0., firstly you have to subtract y

t-1

from both sides of the %&'(

e$uation:

t t t t t t t t

v y x x y y y y + + + + = =

1 1 ) * 1 1 0 1

The ne#t step is to e#press the x in difference form This involves addin" and

subtractin"

1 * t

x

from the ri"ht hand side of the above e$uation

t t t t t t t t

v x y x x x y y + + + + + =

1 * 1 1 ) 1 * * 1 1 0

0ollectin" terms "ives:

t t t t t

v x y x y + + + + + =

1 ) * 1 1 * 0

) ( ) 1 (

+n order to produce the /0., we need to assume that the coefficient on y

t-1

is e$ual to

minus the coefficient on x

t-1

That means:

1

) ( 1

) * 1

) * 1

= + +

+ =

The sum of the coefficients, e#cludin" the constant, must sum to one in the %&'(

model, for the /0. to apply The /0. is usually written with 1 as the coefficient on

the error correction term, to "ive the followin":

) ( ) 1 (

) (

) * 1

1 1 * 0

+ = =

+ + =

t t t t t

u x y x y

The above /0. is the short-run relationship between y and x The lon"-run

relationship can be formed in the usual way, althou"h instead of assumin" all

differenced terms e$ual 0, we assume that they "row at a constant rate g This "ives:

*

) 1 (

*

) 1 ( *) * (

*) * (

* 0

* 0

* 0

x

g

y

g x y

x y g g

+

+

=

+ =

+ =

+f the ori"inal model was:

t t

kx y * * = which in lo"s is

t t

x k y * lo" lo" * lo" + =

Then in terms of the above lon"-run e#pression, when antilo""ed:

2

) 1 (

e#p3

* 0

g

k

+

=

The term k can be interpreted as the lon"-run relationship between y and x ie if y is

consumption and x is wealth, k would be the avera"e propensity to consume from

wealth

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