Stabilizing Error Correction Mechanism in the Presence of Explosiveness

Abstract

In the presence of explosiveness of the adjustment term in the error correction model, the adjustment of the dependent variable Y was too large and overshoots the equilibrium, creating a divergent pattern. The error correction model fails to capture the deviation from equilibrium appropriately, thereby resulting in overshooting of the model. In this paper, a new model to stabilize the explosiveness in an Error Correction model called the stabilizing Error Correction Mechanism was proposed. Mathematical methodology for obtaining the estimate of the model using the Ordinal Least Square method was derived. Error Correction model was used to model the relationship among the variables and the result was compared with the Stabilizing Error Correction Mechanism using root mean square error. A Monte-Carlo simulation was performed, and the stimulation results showed that the error correction model exhibited some explosiveness, and the damping coefficient of the stabilizing model exerted a stabilizing effect on the error correction mechanism, thereby reducing the overshooting in the error correction model. The proposed model contributed to a smoother and more stable response to deviations from the long-run equilibrium. The root mean square error of the stabilizing Error Correction model was observed to be 1.30663, 1.04533, 12.55786, 10.49876, 10.0034, and 19.41545 as compared to the adjustment model in the Error Correction model (60.6888, 35.5929, 315238, 24.31958, 10.1485 and 19.7687) when the persistence is high and (𝜷𝟎,𝜷𝟏,0)=(𝟏,𝟎,𝟎). Therefore, the Stabilizing Error Correction model performs better than the Error Correction model.