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Estimating the LQAC model with I(2) variables
Author(s) -
Engsted Tom,
Haldrup Niels
Publication year - 1999
Publication title -
journal of applied econometrics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 2.878
H-Index - 99
eISSN - 1099-1255
pISSN - 0883-7252
DOI - 10.1002/(sici)1099-1255(199903/04)14:2<155::aid-jae497>3.0.co;2-#
Subject(s) - econometrics , statistics , mathematics
This paper derives a method for estimating and testing the Linear Quadratic Adjustment Cost (LQAC) model when the target variable and some of the forcing variables follow I(2) processes. Based on a forward‐looking error‐correction formulation of the model it is shown how to obtain strongly consistent estimates of the structural parameters from both a linear and a non‐linear cointegrating regression where first‐differences of the I(2) variables are included as regressors (multicointegration). Further, based on the estimated parameter values, it is shown how to test and evaluate the LQAC model using a VAR approach. A simple easy interpretable metric for measuring the model fit is suggested. In an empirical application using UK money demand data, the non‐linear multicointegrating regression delivers an economically plausible estimate of the adjustment cost parameter. However, the restrictions implied by the exact LQAC model under rational expectations are strongly rejected and the metric for model fit indicates a substantial noise component in the model. Copyright © 1999 John Wiley & Sons, Ltd.