STLS / US - VECM 6 . 1 : A Vector Error - Correction Forecasting Model of the US Economy

Any research or policy analysis exercise in economics must be consistent with the timeseries properties of observed macroeconomic data. This paper discusses in detail the specification of a six-variable vector error-correction forecasting model. We test for cointegration among those variables: the CPI, the implicit price deflator for GDP, real money balances (M1), the federal funds rate, the yield on long-term (10-year) government bonds, and real GDP. We also examine the estimated dynamic parameters of the vector error correction structure, and analyze the properties of the model residuals in detail; discuss the forecasting performance of the model with particular reference to the 1990-91 recession and the 1994-95 expansion; compare alternative permanent/transitory decompositions of the data series that are implied by the estimated parameters of the model; discuss the role of weak exogeneity in our estimated structure, and the identifying restrictions that are sufficient to determine a “historical policy rule” within the sample; discuss the conditions required for identification of “dynamic economic models” from the reduced form VECM structure and apply one set of exactly identifying restrictions to derive impulse response functions for a permanent nominal shock and a permanent real shock; and, report some ex-ante forecasts from recent history.