Forecasting Performance Of Alternative Error Correction Models
It is well established that regression analysis on non-stationary time series data may yield spurious results. An earlier response to this problem was to run regression with first difference of variables. But this transformation destroys any long-run information embodied in the levels of variables. According to 'Granger Representation Theorem' (Engle and Granger, 1987) if variables are co-integrated, there exist an error correction mechanism which incorporates long run information in modeling changes in variables. This mechanism employs an additional lag value of the disequilibrium error as an additional variable in modeling changes in variables. It has been argued that ECM performs better for long run forecast than a simple first difference or level regression.