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Energy Economics 18 (1996) 315 334

Stock-Watson dynamic OLS (DOLS) and


error-correction modelling approaches to estimating
long- and short-run elasticities in a demand function:
new evidence and methodological implications
from an application to the demand for coal in
mainland China
Rumi Masih d, Abul M.M. Masih b,*
aDepartment of Applied Economics, Universityof Cambridge. Cambridge CB3 9DE, UK
Department of Economtcs and Management, Universityof New South Wales, Canberra,
ACT 2600, Australia

Abstract

In this paper robust elasticity estimates of coal demand for China are derived using annual
data 1953-92. In so doing, we illustrate the use of a powerful yet practically convenient and
recently developed modelling procedure devised by Stock and Watson (known as Dynamic
OLS (DOLS)), who provide evidence, based on Monte Carlo simulations, of this estimator
being superior in small samples compared to a number of alternative estimators, as well as
being able not only to accommodate higher orders of integration but also to account for
possible simultaneity within regressors of a potential demand system. Furthermore, cointegration and error-correction methods are employed to derive short-run price and income
elasticities. Estimated results are quite robust not only in terms of statistical prowess but
also in terms of economic intuition and indicate that, over the long run, both price and
income elasticities are close to unity. While short-run price and income elasticities are less
(in absolute value) than their long-run counterparts, there seems to be some divergence in
short-run parameters from a subsample analysis. Overall, results seem to imply that for
China, coal consumption should remain relatively constant as future modernization strategies for economic development are pursued. In addition, the study has clear methodological
implications for estimating the long- and short-run elasticities in a demand function in
general, and in a wide variety of fields in future applied research.
* Corresponding author. E-mail: a-masih@adfa.oz.au
0140-9883/96/$15.00 Cc) 10% Elsevier Science B.V. All rights reserved
P I I S 0 1 4 0 - 9 8 8 3 ( 9 6 ) 00016-3

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R. Masih, A.M.M. Masih /Energy Economics 18 (1996) 315 334

J E L classification: Q43; C52

Keywords: China; Coal/energy consumption; Short-/long-run elasticities; Price; Income;


Dynamic OLS

1. Introduction

There have now been several studies devoted to the understanding of the
relationship between macroeconomic variables on the one hand and resource
related variables on the other (see Harvie and Hoa, (1993)). Some have attempted
to study the macroeeonomic effects arising from a variety of resource related
shocks (examples include Pindyck (1980) on effects of the first oil price shock,
Gregory (1976) for the Australian resource boom, Eastwood and Venables (1982)
on reaction from resource hikes in open economies). Others have concentrated on
the specification or modelling approach of energy demand in deriving elasticities
(see Zilberfarb and Adams (1981) for income elasticity estimates of energy consumption using cross-country data for developing countries; Dunkerley (1982) on
estimating energy demand for a selection of developing countries; Hoa (1992) for a
multivariate simultaneous approach in modelling Thai energy demand; Bentzen
and Engsted (1993) in estimating short- and long-run Danish energy demand
elasticities; Engsted and Bentzen (1993) on a rational expectationist approach to
Danish energy demand, and Bentzen (1994) in analysis of Danish gasoline demand).
Related to this is a wide body of literature investigating the causal relationship
between energy consumption and economic growth (see Kraft and Kraft (1978) on
the seminal study finding evidence in support of unidirectional causality from
income to energy for the US; Akarca and Long (1980) who contested these
findings; Abosedra and Baghestani (1991) who re-opened the debate with findings
in support of Kraft's and Kraft's initial study; Stern (1993) who uses an ordinary
vector-autoregression (VAR) with variables in first-difference form on US data
(1947-90) finding evidence against the hypothesis that gross energy Granger causes
GDP, and Masih and Masih (1996c) in an investigation of bivariate causality
between energy consumption and economic growth for six Asian LDCs).
Modelling energy and economic related variables, however, is often associated
with problems of a practical nature which have serious consequences for inference
making based on the estimates. First, apart from the standard problems of
departures from classical assumptions of the regression framework, reduced form
equations typically suffer from endogeneity of regressors leading to simultaneity
among the variables in the system. Secondly, the variables used in such studies are
usually very aggregated and exhibit non-stationarity (see Nelson and Plosser (1982)
and Perron (1988) on evidence of non-stationarity in several macro-aggregates) but
this has been remedied by applications of cointegration techniques (Engle and
Granger, 1987) and developments in error-correction modelling. Thirdly, the small
sample nature of data-sets being employed in energy economics (due mainly to

R. Masih, A.M.M. Masih /Energy Economics 18 (1996) 315-334

317

availability of consistent data) begs the question of the adequacy of applying


standard cointegration techniques in deriving estimates of supposedly long-run
parameters (De Vany and Walls (1993) is one such example which tests for
bivariate cointegration between pairs of spot prices using high frequency daily data,
but only covering a single year). 1
The purpose of this paper is to employ the very recent developments in
modelling long-run or cointegrated relationships which remedy, in part, some of
the above problems, in an application to estimating elasticities of price and income
in coal demand for China employing annual data (1953-92). Specifically, we utilize
a procedure developed by Stock and Watson (1993) known as dynamic OLS
(DOLS) which allows for variables integrated of alternative orders (in this sense, a
higher order of integration), as well as tackling the problem of simultaneity
amongst the regressors. Furthermore, based on Monte Carlo evidence, Stock and
Watson (1993) show that DOLS is more favourable, particularly in small samples,
compared to a number of alternative estimators of long-run parameters, including
those proposed by Engle and Granger (1987), Johansen (1988) and Phillips and
Hansen (1990). Furthermore short-run elasticity counterparts are also derived via
robust dynamic error-correction models (ECMs) (see Bentzen and Engsted (1993)
and Bentzen (1994) in an application of ECMs to energy economics). In this
regard, we aim to provide a unified methodological approach that utilizes these
recent advances in time series econometrics to examine the relationship governing
the demand for a vitally important energy resource, namely coal, in China.
We choose China since work on this country is rather limited with respect to the
role played by the energy or resource sector in its development. Coal is the focus of
this study since it dominates all other sources of resource endowment in China and
is also the primary source of consumption. China is, not surprisingly, the world's
largest coal producer. For our analysis price of coal is also readily available as with
the other variables from various issues of the China Statistical Yearbook published
by the government of China.
Only a few studies, namely Owen and Neal (1989), who analyse China's potential
for a net export earner, and Smil (1988) provide views for energy in China's
development. Recently Tang and La Croix (1993) derive income elasticities for
energy consumption on a provincial level for China using pooled province-level,
cross-section data. While these studies have contributed in improving our understanding of the interaction between energy consumption and the economic development process, there have been none that study the dynamic characteristics of

lOne of the problems associated with employing cointegration techniques is that its power is vitally
dependent upon the actual length of time that the sample period spans. This has been supported in
Monte Carlo studies conducted by Shiller and Perron (1985) and Hakkio and Rush (1991). For purposes
of infcrence making, however, standard tests of hypothesis in regression models are usually associated
more favourably with data on a high frequency, i.e. large sample and asymptotically distributed.
However, as is often the case with long-spanning data, particularly in aggregated variables used ill
energy analysis, only annual data offering a small number of obsevvations can be relied upon to be
available on a consistent basis.

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R. Masih, A.M.M. Masih /Energy Economics 18 (1996) 315-334

these variables over a long time horizon to which the techniques employed in this
paper adequately cover. To this extent, this study helps to fill this void.
The paper is organized in the following manner. Section 2 contains a brief
overview of China's coal endowment, consumption and contribution in economic
growth; a brief and intuitive account of the statistical methodology employed is
provided in Section 3 prior to application of methods and a discussion of results in
Section 4. Some broad policy implications, conclusions and a summary of contributions this study had for future research are made in Section 5.

2. Overview of China's coal endowment

Among all the alternative types of China's resource endowment, coal dominates
by far; so much so that in 1989, it accounted for about 74% of its aggregate energy
production. The coal reserves lie both to the north and southern provinces (Tang
and La Croix, 1993), though its quality is superior in the northern reserves.
According to Tang and La Croix (1993), there are three key features which
determine the structure of China's total energy and coal potential: coal is predominant in China's energy consumption, accounting for almost all (95%) of the
country's primary energy consumption during the 1950s; before declining over the
next two decades and rising again in the 1980s due to too heavy dependence on oil;
while coal endowments have helped in making China a self-sufficient energy
consumer, it has never been a serious candidate for a potential export earner; even
though aggregate energy consumption in China is high in world rankings, it is very
low in terms of per capita consumption (only one-third of the world average).

3. Theoretical model formulation and econometric methodology

3.1. Theoretical model and data

The model used in this analysis is dictated by the typical formulation postulated
by economic theory for aggregate energy demand functions, in its double-log form
as~

logC t = c~ + / 3 ( l o g P t) + 6(logYt) + v~

(1)

where C t is aggregate coal consumption, Pt is the real price of coal and Y,


represents real income (usually GDP), u, is an error term assumed to be white-noise
and normally and identically distributed. Estimation of (1) with adequate data will
provide approximate long-run price and income elasticities. Augmenting lagged
terms will add structure to the dynamics. 2
2Ideally, in a d e m a n d function there ought to be an additional regressor, namely the price of a
substitute of coal. However, due to lack of appropriate data or proxies for the entire length of the
sample period, we could not incorporate such a variable.

R. Masih, A.M.M. Masih /Energy Economics 18 (1996) 315 334

319

1.5

11.5

1.4
11

1.3

10.5

lO

9.5

Co~ C o n ~ m p t m ~ e f t

, ,',

,'1

1.2
1.1

0.9 0
,"''-

Scale

~ ~ . - - "

~l~o~P~e~lgn(~e)

0.8 n"

0.7
8.5

0.6

I I I I I [ I [ : 1 : : l : : I I I I I I I I I I I I I I I I I I I I I I

Fig. l.

0.5

AggregatecoalconsumptionandrealcoalpriceinChina:1953-92.

6.5

11.5

5.5

11

10.5
4.5

lO

" ,~ / . ' ~

9.5

3.5 !

Real Income (Right ScaJe)

2.5 ~

1.5

8.5

0.5

Fig. 2.

Aggregate

coal consumption

and real income

in C h i n a :

1953-92.

The data used in this analysis are annual ranging from 1953 to 1992, and were
obtained from historical annual statistics reported in recent issues of the China
Statistical Yearbook. Plots of aggregate coal consumption compared to real price of
coal and real income are presented in Figs. 1 and 2.

3.2. Econometric methodology


Like all other models that utilize time series data, it is important to recognize
that unless the analytical tools used account for the dynamics of the relationship

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R. Masih, A.M.M. Masih /Energy' Economics 18 (1996) 315-334

within a temporal 'causal' framework, the complexity of the interrelationships


involved may not be fully captured. Hence, there is a requirement for employing
the latest advances in dynamic time-series modelling within a temporal 'causal'
framework that allows for the coexistence of both short- and long-run forces that
drive the often ignored deviating and cyclical influences so inherently interactive
with these aggregate variables over such a time horizon. 3 The following sequential
procedures will be adopted as part as our methodology.

3.2.1. Tests for univariate integration


In order to verify to what degree these series share univariate integration
properties, we perform both unit root tests and mean stationarity tests.
The DF (Dickey and Fuller, 1979, 1981) type tests and the non-parametric
Phillips-Perron (PP) type tests developed by Phillips (1987), Phillips and Perron
(1988), and Perron (1988) are convenient testing procedures, both based on the
null hypothesis that a unit root exists in the autoregressive representation of the
time series. DF tests attempt to account for temporally dependent and heterogeneously distributed errors by including lagged sequences of first differences of the
variable in its set of regressors. The PP tests try to account for dependent and IID
processes through adopting a non-parametric adjustment hence eliminating any
nuisance parameters. 4 Recently these tests have been shown (see Campbell and
Perron (1991) and DeJong et al. (1992)) to suffer from lack of power as they often
tend to accept the null of a unit root too frequently against a stationary alternative.
Moreover, the Phillips-Perron statistics have been shown to perform poorly over
small samples.
These studies have also implied that it would be worthwhile to conduct tests of
the null hypothesis of mean stationarity in order to determine whether variables
are stationary or integrated. Mean stationarity tests are performed with a test
recently proposed by Kwiatkowski et al. (1992). This test (abbreviated as KPSS) is

3See Masih and Masih (1995a, 1996b) for an investigation of the dynamics of economic activity within a
multivariate cointegrated system. Bivariate Granger causality tests using cointegration techniques have
also been undertaken in Masih and Masih (1995c).
4A treatment of the sequential steps involved in applying the PP tests appear in Taylor (1993). Basically,
Perron (1988) shows that if a time series in trend stationary and if no account is made of this in
implementing the testing procedure, this may lead to high probabilities of making a type 11 error. While
the precise form of the assumptions (with regard to distributional properties of error terms, etc) is
contained in Perron (1988), the following sequence is suggested:
(i) Apply Z(t~,), Z ( ~ 2) and Z ( ~ 3) respectively and if the unit root hypothesis is rejected we should
halt the procedure here.
(ii) If the unit root hypothesis cannot be rejected then the greatest power may be obtained by
estimating equations associated with the Phillips-Perron transformations of the relevant t- and
F-statistics, Z(t~,) and Z(qb~). Due to the fact that these two tests are not invariant to the constant
term, this is only valid if the drift term (/x*) used in test equations applied in (i)was zero. In this
respect these two tests should only be used if Z(q~ 2) cannot be rejected.

R. Masih, A.M.M. Masih /Energy Economics 18 (1996) 315-334

321

based on the statistic:


T

r/(u) = ( 1 / T 2) E S ~ / - ~

where

t=l

S t = ~_,v i , t =

1.... T

(2)

i-I

with v, being the residual term from a regression of Yt on an intercept, and cr 2 is a


consistent long-run variance estimate of Yt, and T represents the sample size.
Kwiatkowski et al. (1992) show that the statistic r~(u) has a non-standard distribution and critical values have been provided therein. If the calculated value of ~(u)
is large then the null of stationarity for the KPSS test is rejected. Since we
entertain both the Phillips-Perron tests and the KPSS test in this exercise, we
consider a variable to contain a unit root or be unit-root non-stationary if the null
hypothesis of non-stationarity is not rejected by the PP tests but the null hypothesis
that the variable is mean stationary is rejected by the KPSS test. s
3.2.2. Tests f o r multivariate cointegration

The cointegration technique pioneered by Engle and Granger (1987), Hendry


(1986) and Granger (1986) made a significant contribution towards modelling
stationary relationships while preserving the long-run relationship lost through
differencing. Two or more variables are said to be cointegrated, i.e. they exhibit
long-run equilibrium relationship(s), if they share common trend(s) (for an application of this technique in related disciplines, see Masih and Masih, 1994, 1996b).
According to this technique, if two variables are cointegrated, the finding of no
causality in either direction is also ruled out. As long as the two variables have a
common trend, causality (in the Granger sense, not in the structural sense), must
exist in at least one direction either unidirectional or bidirectional (Granger, 1986,
1988). Evidence of cointegration among variables also rules out the possibility of
the estimated relationship being 'spurious'.
In this analysis we employ the Johansen and Juselius (J J) procedure of testing
for the presence of multiple cointegrating vectors. Unlike its predecessor, the JJ
procedure poses several advantages over the popular residual-based E n g l e - G r a n g e r
two-step approach in testing for cointegration. Specifically, they may be summarized as follows. (i) The JJ procedure does not, a priori, assume the existence of at
most a single cointegrating vector, rather it explicitly tests for the number of
cointegrating relationships. (ii) Unlike the E n g l e - G r a n g e r procedure which is
sensitive to the choice of the dependent variable in the cointegrating regression,
the JJ procedure assumes all variables to be endogenous. (iii) Related to (ii), when
it comes to extracting the residual from the cointegrating vector, the JJ procedure
avoids the arbitrary choice of the dependent variable as in the E n g l e - G r a n g e r
approach, and is insensitive to the variable being normalized. (iv) The JJ procedure

5This guideline in considering the stochastic properties of univariate time series is also used in an
empirical analysis containing error-correction modellingby Mehra (1994).

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R. Masih, A.M.M. Masih /Energy Economics 18 (1996) 315-334

is established on a unified framework for estimating and testing cointegrating


relations withing the V E C M formulation. (v) JJ provides the appropriate statistics
and the point distributions to test hypothesis for the n u m b e r of cointegrating
vectors and tests of restrictions upon the coefficients of the vectors. 6 It is
demonstrated in Johansen (1991) that the procedure involves the identification of
rank of the m by m matrix H in the specification given by:
k-1

Ax, =

r, axt_

+ nx,_

(3)

i=1
where X t is a column vector of the m variables, F and H represent coefficient
matrices, A is a difference operator, k denotes the lag length, and 6 is a constant.
If II has zero rank, no stationary linear combination can be identified. In other
words, the variables in X t are non-cointegrated. If the rank r of H is greater than
zero, however, there will exist r possible stationary linear combinations and H may
be decomposed into two matrices a and /3 (each m r) such that H = a/3'. In
this representation b contains the coefficients of the r distinct cointegrating
vectors that r e n d e r / 3 ' X t stationary, even though X t is itself non-stationary, and a
contains the speed-of-adjustment coefficients for the equation, v
3.2.3. Estimation o f long-run equilibria: Stock-Watson dynamic O L S

One method of extracting purely the long-run coefficients is by the JJ procedure


which is based on an M L E approach. Another more recent and more robust
method, (particularly in small samples) proposed by Stock and Watson (1993),
which also corrects for possible simultaneity bias amongst the regressors, involves
estimation of long-run equilibria via dynamic OLS (DOLS). Stock and Watson
(1993) suggest a parametric approach for estimating long-run equilibria in systems
which may involve variables integrated of different orders but still cointegrated.
The potential of simultaneity bias and small-sample bias among the regressors is
dealt with by the inclusion of lagged and led values of the change in the regressors.
The procedure advocated is similar to recent estimators proposed by Phillips and
Loretan (1991) and Saikkonen (1991), but is much more practically convenient to
implement and estimate.
Model 1

Stock-Watson (1993) Dynamic OLS (DOLS): B = [c, a,/3]', X = [1, Pt, Yt]

6While applications of the JJ procedure have been quite popular in a multivariate context, results
arrived from JJ statistics in bivariate studies have also been shown to be more robust than those arrived
adopting the Engle Granger approach (see, by example, Masih and Masih, 1994, 1995b).
7With respect to both the Engle-Granger and JJ approach, it is important to acknowledge that should
non-cointegration not be rejected at conventional significance levels, it is possible that the residual term
may display fractional behaviour and still be mean-reverting implyingfractional cointegration. For such
an approach see Masih, R. and Masih, A. (1995a).

R. Masih,/t.M.M. Masih /Energy Economics 18 (1996) 315-334


j=J

C, = B ' X t +

323

j=K

~_, ~jAp,_j +
j=-J

~
j=

A/AYt_ / + ~,
K

In estimating the long-run parameters of the demand function, we adopt the DOLS
procedure which basically involves regressing any 1(1) variables on other I(1)
variables, any I(0) variables and leads and lags of the first differences of any I(1)
variables. However, since an investigation of the short-run dynamics are also of
interest in our analysis and important for several other factors of modelling, the
standard VECM formulation described in the later section will also be employed in
facilitating our inferences regarding the short run.
3.2.4. Short-run dynamics: vector error-correction modelling (VECM)
Engle and Granger (1987) demonstrated that once a number of variables are
found to be cointegrated, there always exists a corresponding error-correction
representation which implies that changes in the dependent variable are a function
of the level of disequilibrium in the cointegrating relationship (captured by the
error correction term) as well as changes in other explanatory variable(s).
Assume that we are dealing with non-stationary processes and consider a model
appearing in first differences in a VECM form given by (2). Then by the JJ method
we may deduce the number of cointegrating vectors (using both the trace and
maximum eigenvalue tests) and the /3' vector estimates. The long-run constraints
implied by the estimated cointegrating vectors are imposed by way of constraints in
the simple VAR model (with variables appearing in first-differences) via lagged
error-correction terms.
Model 2
General vector error-correction specification with B = [c, o~,/3 ]', X = [1, P,, Y~]
j=k

j=l

xc, = E 4,j xc _j + E
j=l

j=m

jAe, j +

j=0

q- ~

ajar, j
j=0

~ i ( C t - i - B ' X t _ I ) + 6.t

i=1

Having described what constitutes our VECM, we should place the contributions
of this model in an intuitive context. When the variables are cointegrated, then in
the short term, deviations from this long-term equilibrium will feed back on the
changes in the dependent variable in order to force the movement towards the
long-term equilibrium. If the dependent variable (i.e. say, coal consumption) is
driven directly by this long-term equilibrium error, then it is responding to this
feedback. If not, it is responding only to short-term shocks to the stochastic
environment. The significance tests of the 'differenced' explanatory variables give
us an indication of the 'short-term' effects, whereas the 'long-term' causal relationship is implied through the significance or otherwise of the 't' test(s) of the lagged

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R. Masih, A.M.M. Masih /Energy Economics 18 (1996) 315 334

error-correction term(s), which contains the long-term information since it is


derived from the long-term cointegrating relationship(s). The coefficient of the
lagged error-correction term, however, is a short-term adjustment coefficient and
represents the proportion by which the long-term disequilibrium (or imbalance) in
the dependent variable is being corrected in each short period. Non-significance or
elimination of any of the 'lagged error-correction terms' affects the implied
long-term relationship and may be a violation of theory. The non-significance of
any of the 'differenced' variables which reflects only a short-term relationship,
however, does not involve such violations because, theory typically has nothing to
say about short-term relationships (see Thomas, 1993). By example, applied work
employing this formulation has been used to test for the causal chains implied by
the major paradigms in macroeconomic theory (see Masih and Masih (1995a,
1996b) and Masih, R. and Masih, A. (1995b)).

4. Application and discussion of results

4.1. Univariate integration: tests of the unit root hypothesis


As a prior to tests for multivariate cointegration, several unit root tests as
described in Section 3.2A were carried out. The results of KPSS and PhillipsPerron tests are presented in Table 1 for the full sample and each of two
subsamples (1953 to 1969 and 1970 to 1992).
Table 1 presents results from two tests discussed earlier on the three annual
time series variables. It is quite clear to observe that for all variables the
Phillips-Perron tests of the null hypothesis containing a unit root is quite small
and cannot be rejected at conventional levels of statistical significance. This is true
whether we allow for a deterministic trend to appear in the unit root test
specification or not.
On the other hand, the KPSS test statistic rt(u) that tests the null hypothesis that
a particular variable is mean stationary is large for all variables and further
confirms our earlier conclusion that these variables associated with a demand
model have a unit root and are clearly non-stationary in levels. However, once we
take the first difference of these variables and apply the PP tests, all test values
exceed the critical value (in its absolute value). This leads us to the conclusion that
all series concerned are stationary in their first differences, while being nonstationary in their level form. In other words, we could not find any significant
evidence that [Ct, P,, Y,] were not integrated of order one or 1(1). s
Tests for higher orders of integration were also applied using the procedure
outlined by Dickey and Pantula (1987); however as with several other tests that
were applied, these procedures confirmed the finding that [C,, P,, Y,] were differSUsing the appropriate notation, a series x t is said to be integrated of order d, if it has an invertible
A R M A representation after being differenced d times. For example, a stationary series is indicated by
I(0), whereas a non-stationary series in levels, but stationary in first differences is indicated by 1(1).

R. Masih, A.M.M. Masih /Energy Economics 18 (1996) 315-334

325

Table 1
Kwiatkowski-Phillips-Schmidt Shin (KPSS) tests for mcan stationarity and Phillips Perron (PP) tests
for unit roots a
KPSS

Phillips Perron

Variable

7( Ix)

Panel A: full sample (1953-92)


C,
t]
Yt

0.804**
0.659**
1.017"*

- 1.745
-0.637
-0.394

(-4.018)
( 8.614)
(-4.460)

-2.864
-2.747
-2.087

( 4.025)
( 8.915)
(-4.491)

Yt

0.915"*
0.902**
1.148"*

- 1.741
- 0.868
-0.849

(-3.578)
( - 5.497)
(-4.879)

- 1.818
- 1.913
-1.900

( - 3.898)
( - 5.401)
(-4.809)

Panel C: subsample (1970-92)


Ct
Pt
Yt

0.799**
0.857**
0.983**

-0.216
-0.299
- 1.383

(-4.234)
(-6.878)
( 3.419)

-2.718
-2.191
- 1.926

( 4.073)
(-7.921)
( - 3.945)

Panel B: subsample (1953-69)


C,

Pt

Z(t )

Z(t ,~ )

aThe KPSS test statistic tests the null hypothesis that the variable in question is mean stationary (the
5% critical value for r/(/x) is provided in Kwiatkowski et al. (1992, p. 166, Table 1)). Figures presented in
parentheses for PP tests refer to the adjacent test carried out on the variable in first-differenced (A)
form. Z(t,) is the Phillips-Perron (PP) test allowing for a drift term, whereas Z(t,,) is the PP test
allowing for a drift and a deterministic trend. The null hypothesis is that the variable under consideration contains a unit root in its autoregressive representation. The 5% critical values for a sample size of
50 pertaining to Z(t,) and Z(t~,) are -3.45 and -2.89, respectively. ** indicates rejection of the null
at the 5% level of significance.

e n c e (as o p p o s e d to t r e n d ) s t a t i o n a r y t i m e series p r o c e s s e s . T h e s e results a r e n o t


s u r p r i s i n g g i v e n N e l s o n a n d P l o s s e r ' s (1982) f i n d i n g s t h a t m o s t m a c r o e c o n o m i c
aggregates are difference stationary processes.

4.2. Multivariate cointegration: Johansen-Juselius M L E


Given the common integrational properties of these variables, we then proceeded
to t e s t f o r t h e p r e s e n c e o f c o i n t e g r a t i o n in t h e v e c t o r [C,, Pt, Y,] by u s i n g J o h a n s e n
and Juselius's multivariate MLE procedure. 9 Results of Johansen and Juselius's
L R a n d t r a c e tests a r e p r e s e n t e d in T a b l e 2 f o r t h e t h r e e s a m p l e p e r i o d s a n d
i n d i c a t e q u i t e c o n s i s t e n t l y t h e p r e s e n c e o f at m o s t a single c o i n t e g r a t i n g v e c t o r
a m o n g t h e set o f t h e v a r i a b l e s . T h i s is c o n c l u d e d d u e to t h e e v i d e n c e t h a t null
h y p o t h e s i s o f r = 0, by b o t h tests, is r e j e c t e d at t h e 9 5 % c r i t i c a l values. H o w e v e r , a
s i m i l a r f i n d i n g is n o t o b s e r v e d f o r t h e null o f r < 1 w h i c h c a n n o t b e r e j e c t e d in
f a v o u r o f r = 2. T h i s e v i d e n c e is also c o n s i s t e n t w i t h a n a l t e r n a t i v e c o n c l u s i o n
b a s e d o n S t o c k a n d W a t s o n (1988) t h a t t h e r e exist two i n d e p e n d e n t c o m m o n

9For a more detailed discussion of the JJ procedure than that presented in this paper, see Cuthbertson
et al. (1992), and a wide-ranging survey by Muscatelli and Hum (1992).

326

R. Masih, A.M.M. Masih /Energy Economics 18 (1996) 315-334

Table 2
J o h a n s e n and Juselius's tests for multiple c o i n t e g r a t i n g vectors u
Vector
H~

Hypotheses
H~

Test statistics
Max E i g e n v a l u e ( A )

Trace

Panel A: Full S a m p l e (1953-1992)

[c,, g,Y~]
Panel B: S u b - S a m p l e (1953-1969)
[C,, P,, Y,]

r = 0
r _< 1
r _< 2

r > 0
r > 1
r
3

27.657**
11.204
3.182

42.043**
14.386
3.182

r = 0
r < 1
r < 2

r > 0
r > 1
r = 3

38.567**
7.182
0.878

46.627**
8.059
0.878

r
0
r < 1
r _< 2

r > 0
r > 1
r = 3

21.225"*
9.286
2.509

33.017"*
11.795
2.508

Panel C: Sub-Sample (1970-1992)

[C,,Pt,Y~]

ar indicates the n u m b e r of c o i n t e g r a t i n g relationships. The o p t i m a l lag s t r u c t u r e for the V A R was


selected by m i n i m i z i n g A k a i k e ' s F P E criteria. Critical values are sourced from J o h a n s e n and Juselius
(1990). ** indicates rejection at the 95% critical values.

stochastic trends underlying this set of variables associated with the demand
system.

4.3. Long-run elasticities: Stock-Watson DOLS


Given the presence of cointegration amongst these variables, the intuition
exposed by these results is that the demand system does tend to hold in a long-run
relationship. We may now proceed to derive the long-run elasticities of price and
income with respect to demand for coal.
Stock-Watson DOES parameter estimates of the long-run parameters with all
variables appearing in levels, along with their approximate asymptotic standard
errors, appear in Table 3. This model was estimated including up to j = 4-3 leads
and lags and up to three lags of the equilibrium error without altering results to
any significant degree. The standard errors are due to Newey and West (1987) and
robust in small sample. These robust standard errors facilitate valid inference to be
made upon the coefficients of the variables entering as regressors in levels.
The results indicate fairly clearly that, even allowing for simultaneity bias, both
real price and income variables significantly influence coal consumption in China.
Interestingly, both price and income elasticities as well as being significant and of
the a priori expected signs, are close to unity in their absolute values. At least for
the income elasticity, the unity result is very similar to elasticity estimates found by
Tang and La Croix (1993), over a much smaller sample period (1985 to 1989), in
the case of aggregate energy consumption in China.

R. Masih, A.M.M. Masih /Energy Economics 18 (1996) 315-334

327

Table 3
S t o c k - W a t s o n dynamic OLS long-run parameter estimates of coal demand a
S t o c k - W a t s o n dynamic OLS (DOLS): B = [c, a , / 3 ] ' , X = [1, P~, Y~]
j=l
j=l

C, = B'X, + ~
j=

~7,AP,_i + ~
1

j=

hiaY~_ i + ;,
1

Variable

Estimated value (SE)

Const

6.6179* **
(0.1711)
-0.9914"*
(0.4956)
1.0743* * *
(0.1113)
0.8741'
(0.5216)
-0.4159'**

P~
Y~
A PI
AY~

(0.1184)
APt+ 1
A Pt I
AYt 1

AYt+ L

Sum of squared resids


Re-adjusted

0.3166
(0.4094)
0.6193
(0.3509)
0.2760***
(0.0986)
0.7225**
(0.3137)
0.0933
0.9455

a *** ** and * indicate significance at the 1, 5 and 10% levels.

4.4. Short-run elasticities." V E C M

For short-run parameter estimates, we turn to the vector error-correction model


estimates of model 2 which are presented in Table 4. These results bring to light
several features for inferences regarding the demand for coal in China over the
sample. As can be seen, the coefficients appear to have the predicted signs and
most of them are statistically significant. A general-to-specific approach was
adopted in determining an appropriate lag structure. Further lagged dependent
variables of C t were also tried but did not turn out significant and were therefore
omitted from the regression. Income seems to have a significant and positive effect
but only up to the first lag. The fit, although high, should not be taken too seriously
as error-correction models have been known to be superior for forecasting purposes (see Tegene and Kuchler, 1994). The model also seems to be robust to
various departures from standard regression assumptions in terms of residual
correlation, heteroscedasticity, autoregressive conditional heteroscedasticity
(ARCH), misspecification of functional form, or non-normality of residuals. Stability tests conducted by plotting estimates of CUSUM and CUSUM squares suggest

R. Masih, A.M.M. Masih /Energy Economics ld (1996) 315-334

328

Table 4
Vector error correction models of coal demand a
General vector error-correction specification with B = [c, a , / 3 ]', X = [1, P,, Y~]
j=k

j=!

~c, = Y'. +1at,


/

j. + Y'. ~/,e,

Variable

Full sample

Constant

6.6179* * *
(0.1711)
0.5722***
(0.1178)
- 0.2125 "~
(0.1344)
-0.4243***
(0.1508)
-0.1928"*
(0.1012)
1.1875* * *
(0.1327)
- 0.5989"**
(0.1908)
0.1871"**
(0.0630)
-0.8296***
0.5886***

ACr l
APr
Ap~ i
APt 2
A y~
A Yt- t
'~t I
Price elasticity
Income elasticity
Adjustment
Length (yrs)

5.345

Statistic/test
SSR
1.3651
RZ-adjusted
0.8105
Serial correlation
LMI[ X2(I)]
2.431
LM2[ X 2(2)]
1.759
LM4[ X 2(4)]
1.479
Functional form
R E S E T [F(m,n)] 0.410
Heteroscedasticity
Het [ XZ(I)]
1.482
A R C H [ X2(1 )]
0.059
Normality
J a r q u e - B e r a [ X2(21].998

j=m

~ + 5-'. a/_xY,_j + Y'. ~i(c,


j -= 0

Estimated coefficient (8E)


first subsample
0.0197
(0.0269)
0.4690***
(0.1705)
-0.8221"
(0.4811)

1.2923"* *
(0.1801)
- 0.5578"*
(0.2827)
-0.2122"*
(0.1026)
-0.8221"
0.7346***
4.7116
Summary of diagnostics

B'X,

,) + ~,

Second subsamplc
0.0211"
(0.0127)
0.6340
(0.1813)
- 0./)363
(0.0490)
-0.1415"
(0.0775)
0.0836
10.0821)
0.7048* * *
(0.1 t33)
- 0.6479* **
(0.1631 )
-0.3957***
(0.1135)
-0.2558*
0.0569***
2.5272

0.0897
0.8723

0.0038
0.7057

2.238
0.554
0.257

2.161
2.234
1.179

0.4672

0.992

0.965
0.494

0.384
0.042

2.524

1.241

~'The lag structure was specified using a general to specific approach. SSR refers to the sum of squared
residuals. Distributional properties of diagnostics are respectively: LM(I), LM(2) and LM(4) tests for
the null of 1st, 2nd and 4th order serial correlation amongst the residuals; Het: a test based on
regression of squared residuals on a constant and squares of the fitted values; A R C H : a test for
first-order autoregressive conditional heteroskedastic effects; RESET: Ramsey's REgression Specification E r r o r / ' - t e s t with (m, n) degrees of freedom; and the J a r q u e - B e r a X2(2) L M test for normality of
residuals. *** ** and * indicate significance at the 1, 5 and 10% levels.

R. Masih, A.M.M. Masih /Energy Economics 18 (1996) 315-334

329

that the estimated model is stable over the sample period. This result tends to
suggest that the impact of any structural change over the entire sample period,
although could be evident, at least in terms of model stability, does not appear to
be significant.
There are three noteworthy results these estimates have to offer. The first is in
terms of the importance of the real price of coal in explaining coal demand, in
terms of expected sign and statistical significance. The picture these results portray
seems to be that all variables influence demand in the short term. Prices are quite
important and this result seems to hold regardless of whether income variables are
present or not. The second interesting result is through the statistical significance
and magnitude of the error-correction term. This term (since it appears in its
levels) indicates that real prices and income do, as a component of the long-term
cointegrating relationship through the lagged error-correction term, jointly influence demand over the long term. Thirdly, most intuitively, the error-correction
term is significant with an adjustment coefficient of -0.1871, indicating that in the
case we are off the long-run demand curve, overall demand adjusts to its long-run
equilibrium level with about 18.7% of the adjustment taking place within the first
year (for a detailed interpretation of the significance of the error-correction term
in linear time-series relationships in the presence of model instability, see R.
Masih, (1996)). In other words, given there is a displacement off the long-run
demand curve, the system will take just over five consecutive years to restore a new
equilibrium. In terms of actual time, this is quite slow indicating that prices are
quite sluggish to adjust.
This also implies that coal consumption bears the brunt of any shock to the
demand system. The sign of the ECT coefficient also indicates that changes in the
demand adjust in an opposite direction to the previous period's deviation from
equilibrium. Had the error-correction term not been significant this would imply
that in this estimated model, any short-run adjustment to long-term equilibrium is
primarily through the other variables in the system and not through the channel of
coal consumption.
Finally, as one of our base goals of this analysis, the error-correction model
estimates provide a quantitative assessment of the short-run price and income
elasticity of demand. Given that we are modelling a simple linear relationship with
coal consumption as the dependent variable, the ECM provides a price elasticity
estimate of about -0.8296 for the whole sample period. This result implies that,
although at least in the short run, aggregate demand for coal should decline if the
average price per ton of coal increases, but the decline in quantity demanded is less
than proportionate. Income elasticity estimates are not unlike the short-run price
elasticity estimate, being significantly less than unity in absolute value, although
associated with the expected sign.
In order to assess to what extent there may have been a shift in the short-run
response of coal consumption to changes in prices and income, VECMs were also
specified and estimates over two subsamples incorporating the years 1953-69 in
one sample and 1970-92 in the other. This subsample analysis will also provide us

330

R. Masih, A.M.M. Masih /Energy Economics 18 (1996) 315-334

with further insights into whether there was any significant change in the adjustment parameter.
The sub-sample results are presented alongside the full-sample estimates in
columns 3 and 4 of Table 4. Once again, most coefficients seem to be significant
and most joint lags of price and income are associated with expected signs. A
battery of diagnostic checks does not tend to reveal any violations from standard
error assumptions or model specification. Comparing both subsamples, results for
the initial period seem to be strikingly similar to the estimates derived for the
model over the full sample period, with short-run price and income elasticities of
-0.8221 and 0.7346 respectively. The adjustment coefficient is - 0 . 2 1 1 2 indicating
that it takes about 4.7 years for demand to revert back to a new equilibrium
following an exogenous shock. These results, however, are quite in contrast to
those arrived at after estimating a VECM over the second subsample which
provides a short-run price elasticity of -0.2558 and a short-run income elasticity of
close to zero. Furthermore, the adjustment coefficient is larger (in absolute value)
in the latter sample than in the earlier period, implying a quicker adjustment
length of approximately 2.5 years.

5. Summary, implications and conclusions


The purpose of this paper was to present robust estimates of price and income
elasticities for coal demand in China using annual data from 1953 to 1992. Given
the time span and number of observations the data set provided, separate models
offered by the most recent developments in the econometric/time-series literature
were adopted in estimating long- and short-run price and income elasticities of
demand. In particular, to estimate long-run parameters, a recent technique robust
to simultaneity and small sample bias as well as higher orders of integration,
proposed by Stock and Watson (1993), known as Dynamic OLS was applied with its
superiority over other long-run model estimators. To estimate short-run elasticities,
which are also useful to policy makers, a statistically sound error-correction model
was employed to model the underlying short-term dynamics, without losing any
long-term information inherent in the demand system. From a methodological as
well as energy-systems modelling point of view, this study has illustrated the
statistical as well as intuitive appeal these most recent techniques have to offer for
future applied research in this area and a wide variety of other fields.
In brief, results indicated that long-run estimates of both price and income
elasticities were close to unity. An appropriate error-correction model was estimated to obtain short-run parameters for the full sample and two subsamples
incorporating the years 1953-69 and 1970-92 respectively. In all three models
short-run price and income elasticities were lower, in absolute value, than their
long-run counterparts. In a comparative sense, short-run elasticities for the entire
sample and first subsample tended to be more close to the long-run elasticity
estimates than those found purely over the latter subperiod. The adjustment of a

R. Masih, A.M.M. Masih /Energy Economics 18 (1996) 315-334

331

displacement from the long-run demand curve, seemed to be slightly quicker over
the 1970-92 period than the 1953-69 period.
From this empirical analysis we may draw the following conclusions which may
be of some assistance to economic policy-makers and China's economic and
resource-use plans. First, the evidence of long-run elasticities being close to unity
implies that aggregate intensity of coal consumption should remain constant as
future economic development takes place in China. Secondly, the low short-run
elasticities over the latter half of the sample period could be justified by the fact
that the rate of overall energy consumption during the 1980s, in particular, was
much lower than the rapid use of energy to foster China's economic development,
experienced during the 1950s and 1960s. Third, although there appears to be a
divergence of short-run elasticities over the two subsample periods, the overall
relationship was found to be quite robust as well as stable.
Given that coal dominates China's share of natural resource endowment and the
availability of adequate published price data, this analysis was limited to estimating
parameters involving a particular component of China's energy endowment. Moreover, a simple linear relationship was specified dictated by very fundamental
theoretical postulates. Time-series data permitting, an interesting exercise would
be to conduct similar analyses for deriving elasticities of China's other three major
conventional energy resources: oil, natural gas and hydropower. This would provide
a much broader and general overview of energy demand behaviour in China and
also contribute valuable insights into the effectiveness of China's energy price
reforms, especially in the light of its recent modernization strategies. More importantly, such analysis would also hold implications for Chinese total energy consumption and conservation policies in the prospective future.

Acknowledgements
Authors would like especially thank: Jim Stock, Soren Johansen, Jesus Gonzalo,
F. Gerard Adams, Katarina Juselius, Deane Terrell, Sean Holly, Warwick
McKibbin and Adrian Pagan for their very helpful comments and discussions; and
Sam Jegatheswaran who provided most able research assistance. The second
author would also like to acknowledge financial support provided through a
University of New South Wales Special Research Grant. Any remaining errors
a n d / o r omissions are attributable solely to the authors who also equally share
responsibility to the paper.

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