On Error Correction Models: Specification, Interpretation, Estimation

Error Correction Models (ECMs) have proved a popular organising principle in applied econometrics, despite the lack of consensus as to exactly what constitutes their defining characteristic, and the rather limited role that has been given to economic theory by their proponents. This paper uses a historical survey of the evolution of ECMs to explain the alternative specifications and interpretations and proceeds to examine their implications for estimation. The various approaches are illustrated for wage equations by apphcation to UK labour market data 1855-1987. We demonstrate that error correction models impose strong and testable non-linear restrictions on dynamic econometric equations, and that they do not obviate the need for modelling the process of expectations formation. With the exception of a few special cases, both the non- linear restrictions and the modelling of expectations have been ignored by those who have treated ECMs as merely reparameterisations of dynamic linear regression models or vector autoregressions.

Journal of Economic Surveys (with Ron Smith)

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Tests of alternative wage employment bargaining models, with an application to the UK aggregate labour market

In this paper we propose a test that discriminates among alternative models of bargaining for wages and employment. The test rests on a theoretical framework which encompasses both the labour demand and the efficient bargain models of wage and employment determination. It is based on testing the cross equation restrictions implied for the coefftcients of union power variables in reduced form wage and employment equations. The test is illustrated for the Layard and Nickell model of the aggregate UK labour market, for which it is found that one can reject both the labour demand model and the hypothesis that wage employment bargains are efficient, in favour of a generalised model of inefficient bargaining for wages and employment.

European Economic Review (with Alan Manning)

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Monetary, Nominal Income and Exchange Rate Targets in a Small Open Economy

In this paper I examine the properties of monetary, nominal income and exchange rate targets, as stabilization policies in an open economy. Perfect capital mobility and a wide variety of transitory random shocks is assumed. Nominal wages are assumed to have been set in advance of the realization of the shocks. None of these rules is in general sufficient to minimize the welfare cost of aggregate fluctuations, and none necessarily dominates all others. Under the assumption that monetary control is subject to random errors optimal policy implies reactions to all observable shocks, and is characterized by heavy exchange market intervention.

European Economic Review

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On the Persistence of Unemployment

A comparison of unemployment across fourteen European countries, Japan and the US shows a great diversity of persistence: high in most of Europe outside the Scandinavian countries, Austria and Switzerland, low in Japan and the US.

Three reasons for unemployment persistence are examined. First, employed workers may not care about the unemployed, and only wish to protect their own jobs. The authors find little support for this view, except perhaps in the US. Second, workers may be reluctant to revise downward their wage aspirations. This seems to be the case in Europe, as opposed to the US and Japan. Third, firms may be slow in adjusting employment to its optimum level. This is the case in Europe and Japan, not in the US.

Labour market reforms might help, but have their own costs. The authors conclude that the best course of action is a demand expansion combined with incomes policies.

Economic Policy (with Alan Manning)

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Wage Setting and Unemployment Persistence in Europe, Japan and the USA

In this paper we set out to directly distinguish between insider membership dynamics and other sources of unemployment persistence. Our findings suggest that there are not sufficient differences in insider membership dynamics between the European economies and the United States. Thus, one cannot appeal to this source to justify the difference in their unemployment experience after the mid-seventies. This is in marked contrast to the conclusion of Blanchard and Summers. We suggest that their conclusions are sensitive to the way of approximating the natural rate of unemployment. Our second conclusion concerns sluggishness in labour demand. We find evidence of significant sluggishness in the three European economies and no sluggishness in the U.S.A. and Japan. This tentatively suggests that the persistence of European unemployment after the recent demand and supply shocks may have to do with this source.In section 2 we briefly present a version of the Blanchard and Summers model of wage and employment setting. In section 3 we modify and extend the model, and present estimates of the hysteresis coefficient, that measures the extent to which past employment determines the size of the group of insiders in wage negotiations. In section 4 we briefly investigate sluggishness in labour demand, and the conclusions are summed up in the final section.

European Economic Review (with Alan Manning)

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On Intertemporal Substitution and Aggregate Labor Supply

In this paper I present an econometric investigation of the implications of the intertemporal substitution hypothesis for aggregate employrnent in the United States. The tests are based on a version of the hypothesis with time-separable preferences. On the basis of the evidence produced, the hypothesis is quite successful in explaining fluctuations in aggregate employment, although almost totally unsuccessful in accounting for fluctuations in employee hours. These findings suggest that the hypothesis might have an important role to play in macroeconomic modeling, although they contradict attempts to account for aggregate fluctuations solely in terrns of continuous competitive equilibrium in labor markets.

Journal of Political Economy

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Aggregate Employment and Intertemporal Substitution in the UK

On the basis of the results of this paper, theories that rest on intertemporal substitution and continuous market clearing do not appear to be supported by the evidence. The features of the estimates for the total number of employees do however suggest that maybe an extension of the theory to account for serial persistence, or the possibility of rationing in the labour market, might result in a role for intertemporal substitution in macroeconomic modelling. The structure of the paper is as follows. In section I, I present the theoretical model. Time series estimates and tests are in section II.In section III, an attempt is made to compare the estimates to alternative labour market models. I argue that, in principle, intertemporal substitution models predict similar correlations between employment and wage and price inflation as for example Sargan (1964)-type wage equations, and that it is not too surprising that they fit reasonably well to UK time series. There is an observational equivalence problem, which, nevertheless, should be possible to resolve. This and other conclusions are summed up in the final section.

The Economic Journal

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