Interpreting an Error Correction Model: Partial Adjustment, Forward-Looking Behaviour, and Dynamic International Money Demand.

An error correction model is derived from a stochastic dynamic programming problem incorporating rational expectations. A parametric restriction is derived that allows a test for the theoretical proposition that the optimal strategy behind the error correction form entails the failure to asymptotically close the gap between the choice variable and the growing target. This is accomplished by nesting a partial adjustment model with forward-looking expectations within the error correction paradigm. The counterintuitive behavior embodied in the error correction model is not supported by the data in the context of a cross-country comparison of cash balances relationships. Copyright 1990 by John Wiley & Sons, Ltd.