Friday, August 2, 2013

Allocation Models With Autocorrelated Errors

Not too long ago, I had a couple of posts about "allocation models" (here and here). These models are systems of regression equations in which there is a constraint on the data for the dependent variables for the equations. Specifically, at every point in the sample, these variables sum exactly to the value of a linear combination of the regressors. In practice, this linear combination usually is very simple - it's just one of the regressors.

So, for example, suppose that the dependent variables measure the shares of Canada's exports that go to different countries. These shares must add up to one in value. If we have an intercept (a series of "ones") in each equation, then we have an allocation model.

In one of the comments on the earlier posts, I was asked about the possibility of autocorrelated errors in the empirical example that I provided. In my response, I noted that if autocorrelation is present, and is allowed for in the estimation of the model, then special care is needed. In particular, any modification to the model, to allow for a specific form of autocorrelation, must satisfy the "adding up" constraints that are fundamental to the allocation model.

Let's see what this involves, in practice.