An Empirical Application and Monte Carlo Analysis of Tests of Dynamic Specification

structure of economic relationships has long been recognised (e.g. Nerlove (1972)), and has caused some researchers recently to rely almost exclusively on the methods of time series analysis for model building with economic time series data. Furthermore, a number of studies of the forecasting performance of econometric models vis a' vis that of time series models (e.g. Naylor etal (1972) and further references in Prothero and Wallis (1977)) have been interpreted as demonstrating the superiority of time series model building methodology over that of econometrics. To the extent that econometric models have been based on static economic theory, with dynamics possibly introduced via serially correlated error processes, or have been in the mould of simple models involving first order dynamics such as the partial adjustment and adaptive expectations models, the implied criticism of econometric modelling is probably valid. However, econometricians need not restrict the range of models and techniques in this way, for they are fortunate in being able to combine structural information from economic theory, (especially for long-run equilibrium or steady-state behaviour), with the techniques of time series analysis and those of econometrics. We believe that the econometrician's search for an acceptable representation of the process generating the data being analysed is made easier by the use of both economic theory and the methods of time series analysis, and that the latter are complementary to econometric methods rather than substitutes for them. Rather than abandoning an econometric approach to modelling altogether and using " black-box " time series methods, we favour an approach which uses reasonable statistical procedures to test various hypotheses (which are too often arbitrarily selected and assumed to be valid), contained within a general unrestricted model, and then incorporates this evidence in a model whose structure is suggested by general economic considerations, to obtain an