Granger Causality

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Introducing Granger Causality

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Granger Causality

  1. 1. Granger Causality Guy Lion December 2005
  2. 2. Granger Causality vs “Causality” <ul><li>Granger causality measures whether A happens before B and helps predict B. </li></ul><ul><li>A Granger causing B may entail “real”causality. But, you can’t be sure. </li></ul><ul><li>If A does not Granger cause B. You can be more confident, A does not cause B. </li></ul>
  3. 3. Granger Causality steps <ul><li>Develop a Base case autoregressive model using dependent variable and its lagged values as independent variable. </li></ul><ul><li>Develop a Test case model by adding a second lagged independent variable you want to test. </li></ul><ul><li>Calculate the square of the residual errors for the two models and run an F test or t Test (unpaired) to check if the residuals are significantly lower when you add tested second variable. </li></ul><ul><li>Redo steps 1 through 3, but reverse the direction. By comparing the tests significance or P value, you can see if A Granger causes B more than B Granger causes A. </li></ul>
  4. 4. The Basic Picture Independent Variable being tested
  5. 5. The Whole Picture
  6. 6. Does Loan  Granger cause Deposit  Data source: quarterly basis since 2 nd quarter of 1987. Total loans and total deposits aggregated from Fed Data Flow of Funds Accounts (L109, L215, L216, L217, L222). Let’s test if Loan  Granger causes Deposit  . We will use Loan  with a 4 quarter lag since it has the highest correlation with Deposit  .
  7. 7. t Test (unpaired) (Loans cause Deposits) The Test model achieved a higher adjusted R Square of 0.41 vs the Base case model’s 0.28.
  8. 8. t Test (unpaired) (Deposits cause Loans) The Test model achieved a lower adjusted R Square of 0.45 vs the Base case model’s 0.46.
  9. 9. Loans  Granger causes Deposits  more than the reverse

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