What is Error Correction Model (ECM)?
An Error Correction Model (ECM) is specifically designed to handle non-stationary data by addressing both short-term dynamics and long-term equilibrium relationships between time series variables. The term “error correction” refers to the mechanism by which deviations from the long-run equilibrium are corrected over time.
In an ECM, the error correction term represents the extent to which the previous period’s disequilibrium influences the current period’s adjustments. This allows the model to capture both short-term fluctuations and the speed at which the variables return to equilibrium.
Error Correction Model (ECM): A Comprehensive Guide
An Error Correction Model (ECM) is a powerful econometric tool used to model the relationship between non-stationary time series variables that are cointegrated. Cointegration implies that while individual time series may be non-stationary, a linear combination of them is stationary, indicating a long-run equilibrium relationship. ECMs are particularly useful for capturing both short-term dynamics and long-term equilibrium adjustments between variables.
Table of Content
- What is Error Correction Model (ECM)?
- How ECMs Manage Non-Stationary Data?
- 1. Understanding Non-Stationarity and Cointegration
- 2. Engle-Granger Two-Step Procedure
- 3. Model Specification
- 4. Handling Mixed Integration Orders
- Steps to Estimate an Error Correction Model (ECM)
- Interpreting Error Correction Models: Key Components and Their Significance
- Practical Application and Use Cases of ECM
- Advantages and Disadvantages of ECM
- Key Differences Between ECM and Other Time Series Models