Restrictions on variables

Abstract

Accounting identities impose exact restrictions on the endogenous variables of econometric models. Such restrictions are usually met by choosing a closing entry or by building an allocation model. Selecting a closing entry may be difficult or arbitrary, while allocation models admit little flexibility in the choice of explanatory variables and lagged adjustment schemes. This paper studies a third solution which in a sense lies inbetween: freely chosen equations for all variables are adjusted additively such that the restrictions will hold. The adjustment involves some new parameters which can be estimated simultaneously with the original parameters using Maximum Likelihood techniques. An application is provided for a financial model of the Dutch private sector. Our approach here proves superior to any choice of closing entry in the system.