Vector rational error correction

Systems of forward-looking linear decision rules can be formulated as vector ‘rational’ error correction models. The closed-form solution of the restricted error corrections is derived, and a full-information estimator is suggested. The error correction format indicates that the assumptions of convex adjustment costs and rational expectations impose different types of a priori restrictions on the dynamic structure of the error corrections. An empirical model of the producer decision rule for capital investment illustrates that the data rejects dynamic restrictions imposed by a standard model of adjustment costs but supports a more general description of convex frictions.