Forecasting with Equilibrium-correction Models during Structural Breaks

Jennifer L. Castle (), Nicholas W.P. Fawcett and David F. Hendry ()

No 408, Economics Series Working Papers from University of Oxford, Department of Economics

Abstract: When breaks occur, equilibrium-correction models (EqCMs) based on cointegration face forecasting problems. We investigate approaches to alleviate forecast failure following a location shift, including updating, intercept corrections, differencing, and estimating the future impact of an ‘internal’ break during its progress. Although updating can lead to a loss of cointegration when an EqCM suffers an equilibrium-mean shift, we show that updating can help when collinearities are changed by an ‘external’ break and the EqCM itself remains constant. Both mechanistic corrections help compared to just retaining a pre-break estimated model, but an estimated model of the break process could outperform. Throughout, we apply the approaches to the much-studied example of EqCMs for UK M1, and compare with updating a learning function as the break evolves.

Keywords: Forecasting; Location Shifts; Equilibrium-Correction Models (search for similar items in EconPapers)
JEL-codes: C1 C53 (search for similar items in EconPapers)
Date: 2008
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