The Role of Economic Theory in Modelling the

Long Run(Pesaran)

Summary by Xavier Quiel 1764438

January 17, 2011

1 Introduction
Pesaran favors a theory based procedure ,with a priori restrictions. He favors
formulating the long run as steady state solutions of intertemporal optimisation
problems. Also suggesting to revive some old methods from the dead instead of
using cointegration theory. Now that we know what Pesaran wants it might be
interesting to look at why he prefers this method.
An important advantage of a theory based proced is that you interpret the
results better, so you get better theoratical insight and possibly sound economic
reasoning. Besides this you have the possiblity of imposing short run dynamics
on you model.
Formulating the long run as the long run equilibrium has two imporant ad-
vantages. The model embodies a set of theory consistent steady state realtions.
Number two is that this allows the model’s long run properties to be studied
empirically. If you formulate your model this way you can use intertemporal
optimisation techniques.

2 Step by step
Well it’s basically two steps: modelling and estimation.

2.1 The model

Now we have to model the long run relations within the intertemporal optimi-
sation framework. This leaves the short-run modelling free to your preferences.
You can use a VAR-model with unrestricted short-run coefficients or restrict the
dynamics of adjustment to the long run equilibrium, either way you continue
the same. Now it depends if your problem is of LQ-form or not.
If it is indeed of LQ-form it is quite easy to implement. You should write your
problem in the cononical multivariate rational expectation model, as suggested
by Pesaran. If your problem is not of LQ-from, you have a problem. Your best
hope is to replace it with a model of LQ-form that approximates the original.

1
 The approach taken above implies that there is a ’single’ representative
agent, if this isn’t the case estimation of your model can go wrong. So use
pooling. This can be done if theory predicts the same long run relations, short-
run isn’t important in this case.

2.2 Estimation
Pesaran makes a distinction between to cases a single long run relation or mul-
tiple.

2.2.1 Single relation

First you have to determine the order of the ARDL model this can be done by ei-
ther the Akaike Information Criterion or the Schwartz Bayesian Criterion.Then
if your model is rewritten in this form you can estimate the long-run coefficients
using the L.S estimator of the ARDL-model.

2.2.2 Multiple relations

If the long-run relations are identified you can estimate them by incorporating
them within the VARDL(p,q) model. If the forcing variables are strictly exoge-
nous standard methods can be applied. If this isn’t the case, start reading the
Pesaran paper instead of this summary.

2.2.3 Aggregation
The approach taken implies that there is a ’single’ representative agent, if this
isn’t the case estimation of your model can go wrong. So use pooling. This can
be done if theory predicts the same long run relations, short-run isn’t important
in this case. Then estimate all the coefficients one by one of the different groups.

3 Conclusion
Pesaran in his paper argued against the use of cointegration theory. Instead
stessing the point that using intertemporal optimisation techniques from eco-
nomic theory is important. Special attention is needed when problems are non-
LQ or in the case of aggregation.
The abandonment of traditional methods in favor of cointegration techniques
has been premature, because of the serious pre-testing problems.
The usefulness of Pesaran’s method depends on the speed on convergence to
the equilibrium.
Although Pesaran argues in favor of a theory based model, Granger(1997)
warns that these model don’t perform as well as unrestricted models.