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- 1. UNIVERSITY OF ECONOMICS, HO CHI MINH CITY FACULTY OF DEVELOPMENT ECONOMICS TIME SERIES ECONOMETRICS CAUSALITY MODELS Compiled by Phung Thanh Binh1 (2010) “You could not step twice into the same river; for other waters are ever flowing on to you.” Heraclitus (540 – 380 BC)The aim of this lecture is to provide you with the keyconcepts of time series econometrics. To its end, youare able to understand time series based researches,officially published in international journals2 suchas applied economics, applied econometrics, and thelikes. Moreover, I also expect that some of you willbe interested in time series data analysis, and choosethe related topics for your future thesis. As the timethis lecture is compiled, I believe that the Vietnam1 Faculty of Development Economics, University of Economics, HCMC. Email: ptbinh@ueh.edu.vn.2 Selected papers were compiled by Phung Thanh Binh & Vo Duc Hoang Vu (2009). You can find themat the H library. 1
- 2. time series data3 is long enough for you to conductsuch studies. Specifically, this lecture will provide you thefollowing points: An overview of time series econometrics Stationary versus non-stationary Unit roots and spurious regressions Testing for unit roots Vector autoregressive models Causality tests Cointegration and error correction models Optimal lag length selection criteria Basic practicalities in using Eviews 6.0 Suggested research topics1. AN OVERVIEW OF TIME SERIES ECONOMETRICSIn this lecture, we will mainly discuss singleequation estimation techniques in a very different wayfrom what you have previously learned in the basiceconometrics course. According to Asteriou (2007),there are various aspects to time series analysis butthe most common theme to them is to fully exploit thedynamic structure in the data. Saying differently, wewill extract as much information as possible from the3 The most important data sources for these studies can be World Bank’s World Development Indicators,IMF-IFS, GSO, and Reuters Thomson. 2
- 3. past history of the series. The analysis of timeseries is usually explored within two fundamentaltypes, namely time series forecasting4 and dynamicmodelling. Pure time series forecasting, such as ARIMAmodels5, is often mentioned as univariate analysis.Unlike most other econometrics, in univariate analysiswe do not concern much with building structuralmodels, understanding the economy or testinghypothesis6, but what we really concern is developingefficient models, which are able to forecast well. Theefficient forecasting models can be evaluated usingvarious criteria such as AIC, SBC7, RMSE, correlogram,and fitted-actual value comparison8. In these cases,we try to exploit the dynamic inter-relationship,which exists over time for any single variable (say,sales, GDP, stock prices, ect). On the other hand,dynamic modelling, including bivariate andmultivariate time series analysis, is still concernedwith understanding the structure of the economy andtesting hypothesis. However, this kind of modelling isbased on the view that most economic series are slowto adjust to any shock and so to understand theprocess must fully capture the adjustment processwhich may be long and complex (Asteriou, 2007). Thedynamic modelling has become increasingly popularthanks to the works of two Nobel laureates, namely,4 See Nguyen Trong Hoai et al, 2009.5 You already learned this topic from Dr Cao Hao Thi.6 Both statistical hypothesis and economic hypothesis.7 SBC and SIC are interchangeably used in econometrics books and empirical studies.8 See Nguyen Trong Hoai et al, 2009. 3
- 4. Clive W.J. Granger (for methods of analyzing economictime series with common trends, or cointegration) andRobert F. Engle (for methods of analyzing economictime series with time-varying volatility or ARCH)9. Upto now, dynamic modelling has remarkably contributedto economic policy formulation in various fields.Generally, the key purpose of time series analysis isto capture and examine the dynamics of the data. In time series econometrics, it is equally importantthat the analysts should clearly understand the term“stochastic process”. According to Gujarati (2003)10, arandom or stochastic process is a collection of randomvariables ordered in time. If we let Y denote a randomvariable, and if it is continuous, we denote it aY(t), but if it is discrete, we denote it as Yt. Sincemost economic data are collected at discrete points intime, we usually use the notation Yt rather than Y(t).If we let Y represent GDP, we have Y1, Y2, Y3, …, Y88,where the subscript 1 denotes the first observation(i.e., GDP for the first quarter of 1970) and thesubscript 88 denotes the last observation (i.e., GDPfor the fourth quarter of 1991). Keep in mind thateach of these Y’s is a random variable. In what sense we can regard GDP as a stochasticprocess? Consider for instance the GDP of $2872.8billion for 1970Q1. In theory, the GDP figure for thefirst quarter of 1970 could have been any number,depending on the economic and political climate then9 http://nobelprize.org/nobel_prizes/economics/laureates/2003/10 Note that I completely cite this from Gujarati (2003). 4
- 5. prevailing. The figure of $2872.8 billion is just aparticular realization of all such possibilities. Inthis case, we can think of the value of $2872.8billion as the mean value of all possible values ofGDP for the first quarter of 1970. Therefore, we cansay that GDP is a stochastic process and the actualvalues we observed for the period 1970Q1 to 1991Q4 area particular realization of that process. Gujarati(2003) states that the distinction between thestochastic process and its realization in time seriesdata is just like the distinction between populationand sample in cross-sectional data. Just as we usesample data to draw inferences about a population; intime series, we use the realization to draw inferencesabout the underlying stochastic process. The reason why I mention this term before examiningspecific models is that all basic assumptions in timeseries models relate to the stochastic process(population). Stock & Watson (2007) say that theassumption that the future will be like the past is animportant one in time series regression. If the futureis like the past, then the historical relationshipscan be used to forecast the future. But if the futurediffers fundamentally from the past, then thehistorical relationships might not be reliable guidesto the future. Therefore, in the context of timeseries regression, the idea that historicalrelationships can be generalized to the future isformalized by the concept of stationarity. 5
- 6. 2. STATIONARY STOCHASTIC PROCESSES2.1 DefinitionAccording to Gujarati (2003), a key concept underlyingstochastic process that has received a great deal ofattention and scrutiny by time series analysts is theso-called stationary stochastic process. Broadlyspeaking, a stochastic process is said to bestationary if its mean and variance are constant overtime and the value of the covariance between the twoperiods depends only on the distance or gap or lagbetween the two time periods and not the actual timeat which the covariance is computed. In the timeseries literature, such a stochastic process is knownas a weakly stationary, or covariance stationary, orsecond-order stationary, or wide sense, stochasticprocess. By contrast, a time series is strictlystationary if all the moments of its probabilitydistribution and not just the first two (i.e., meanand variance) are invariant over time. If, however,the stationary process is normal, the weaklystationary stochastic process is also strictlystationary, for the normal stochastic process is fullyspecified by its two moments, the mean and thevariance. For most practical situations, the weak typeof stationarity often suffices. According to Asteriou(2007), a time series is weakly stationary when it hasthe following characteristics: (a) exhibits mean reversion in that it fluctuates around a constant long-run mean; 6
- 7. (b) has a finite variance that is time-invariant; and (c) has a theoretical correlogram that diminishes as the lag length increases.In its simplest terms a time series Yt is said to beweakly stationary (hereafter refer to stationary) if: (a) Mean: E(Yt) = µ (constant for all t); (b) Variance: Var(Yt) = E(Yt-µ)2 = σ2 (constant for all t); and (c) Covariance: Cov(Yt,Yt+k) = γk = E[(Yt-µ)(Yt+k-µ)]where γk, covariance (or autocovariance) at lag k,isthe covariance between the values of Yt and Yt+k, thatis, between two Y values k periods apart. If k = 0, weobtain γ0, which is simply the variance of Y (=σ2); ifk = 1, γ1 is the covariance between two adjacent valuesof Y. Suppose we shift the origin of Y from Yt to Yt+m(say, from the first quarter of 1970 to the firstquarter of 1975 for our GDP data). Now, if Yt is to bestationary, the mean, variance, and autocovariance ofYt+m must be the same as those of Yt. In short, if atime series is stationary, its mean, variance, andautocovariance (at various lags) remain the same nomatter at what point we measure them; that is, theyare time invariant. According to Gujarati (2003), suchtime series will tend to return to its mean (calledmean reversion) and fluctuations around this mean(measured by its variance) will have a broadlyconstant amplitude. 7
- 8. If a time series is not stationary in the sense justdefined, it is called a nonstationary time series. Inother words, a nonstationary time series will have atime-varying mean or a time-varying variance or both. Why are stationary time series so important?According to Gujarati (2003), because if a time seriesis nonstationary, we can study its behavior only forthe time period under consideration. Each set of timeseries data will therefore be for a particularepisode. As a consequence, it is not possible togeneralize it to other time periods. Therefore, forthe purpose of forecasting or policy analysis, such(nonstationary) time series may be of little practicalvalue. Saying differently, stationarity is importantbecause if the series is nonstationary, then all thetypical results of the classical regression analysisare not valid. Regressions with nonstationary timeseries may have no meaning and are therefore called“spurious” (Asteriou, 2007). In addition, a special type of stochastic process(or time series), namely, a purely random, or whitenoise, process, is also popular in time serieseconometrics. According to Gujarati (2003), we call astochastic process purely random if it has zero mean,constant variance σ2, and is serially uncorrelated.This is similar to what we call the error term, ut, inthe classical normal linear regression model, oncediscussed in the phenomenon of serial correlationtopic. This error term is often denoted as ut ~iid(0,σ2). 8
- 9. 2.2 Random Walk ProcessAccording to Stock and Watson (2007), time seriesvariables can fail to be stationary in various ways,but two are especially relevant for regressionanalysis of economic time series data: (1) the seriescan have persistent, long-run movements, that is, theseries can have trends; and, (2) the populationregression can be unstable over time, that is, thepopulation regression can have breaks. For the purposeof this lecture, I only focus on the first type ofnonstationarity. A trend is a persistent long-term movement of avariable over time. A time series variable fluctuatesaround its trend. There are two types of trends seenin time series data: deterministic and stochastic. Adeterministic trend is a nonrandom function of time(i.e., Yt = a + b*Time, Yt = a + b*Time + c*Time2, andso on). In contrast, a stochastic trend is random andvaries over time. According to Stock and Watson(2007), it is more appropriate to model economic timeseries as having stochastic rather than deterministictrends. Therefore, our treatment of trends in economictime series focuses on stochastic rather thandeterministic trends, and when we refer to “trends” intime series data, we mean stochastic trends unless weexplicitly say otherwise. The simplest model of a variable with a stochastictrend is the random walk. There are two types ofrandom walks: (1) random walk without drift (i.e., no 9
- 10. constant or intercept term) and (2) random walk withdrift (i.e., a constant term is present). The random walk without drift is defined as follow.Suppose ut is a white noise error term with mean 0 andvariance σ2. The Yt is said to be a random walk if: Yt = Yt-1 + ut (1)The basic idea of a random walk is that the value ofthe series tomorrow is its value today, plus anunpredictable change. From (1), we can write Y1 = Y0 + u1 Y2 = Y1 + u2 = Y0 + u1 + u2 Y3 = Y2 + u3 = Y0 + u1 + u2 + u3 Y4 = Y3 + u4 = Y0 + u1 + … + u4 … Yt = Yt-1 + ut = Y0 + u1 + … + utIn general, if the process started at some time 0 witha value Y0, we have Yt = Y0 + ∑ u t (2)therefore, E(Yt ) = E(Y0 + ∑ u t ) = Y0In like fashion, it can be shown that Var (Yt ) = E(Y0 + ∑ u t − Y0 ) 2 = E(∑ u t ) 2 = tσ 2Therefore, the mean of Y is equal to its initial orstarting value, which is constant, but as t increases,its variance increases indefinitely, thus violating a 10
- 11. condition of stationarity. In other words, thevariance of Yt depends on t, its distribution dependson t, that is, it is nonstationary. Figure 1: Random walk without drift 8 4 0 -4 -8 -12 -16 -20 50 100 150 200 250 300 350 400 450 500Interestingly, if we re-write (1) as (Yt – Yt-1) = ∆Yt = ut (3)where ∆Yt is the first difference of Yt. It is easy toshow that, while Yt is nonstationary, its firstdifference is stationary. And this is very significantwhen working with time series data. The random walk with drift can be defined as follow: Yt = δ + Yt-1 + ut (4)where δ is known as the drift parameter. The namedrift comes from the fact that if we write thepreceding equation as: 11
- 12. Yt – Yt-1 = ∆Yt = δ + ut (5)it shows that Yt drifts upward or downward, dependingon δ being positive or negative. We can easily showthat, the random walk with drift violates bothconditions of stationarity: E(Yt) = Y0 + t.δ Var(Yt) = tσ2In other words, both mean and variance of Yt dependson t, its distribution depends on t, that is, it isnonstationary. Figure 2: Random walk with drift 30 25 20 15 10 5 0 -5 -10 50 100 150 200 250 300 350 400 450 500 Yt = 2 + Yt-1 + ut 12
- 13. Figure 3: Random walk with drift 10 5 0 -5 -10 -15 -20 -25 50 100 150 200 250 300 350 400 450 500 Yt = -2 + Yt-1 + utStock and Watson (2007) say that because the varianceof a random walk increases without bound, itspopulation autocorrelations are not defined (the firstautocovariance and variance are infinite and the ratioof the two is not well defined)11.2.3 Unit Root Stochastic ProcessAccording to Gujarati (2003), the random walk model isan example of what is known in the literature as aunit root process.11 Cov(Yt , Yt −1 ) ∞ Corr(Yt,Yt-1) = ~ Var (Yt )Var (Yt −1 ) ∞ 13
- 14. Let us write the random walk model (1) as: Yt = ρYt-1 + ut (-1 ≤ ρ ≤ 1) (6)This model resembles the Markov first-orderautoregressive model, mentioned in the basiceconometrics course, autocorrelation topic. If ρ = 1,(6) becomes a random walk without drift. If ρ is infact 1, we face what is known as the unit rootproblem, that is, a situation of nonstationarity. Thename unit root is due to the fact that ρ = 1.Technically, if ρ = 1, we can write (6) as Yt – Yt-1 =ut. Now using the lag operator L so that Lyt = Yt-1, L2Yt= Yt-2, and so on, we can write (6) as (1-L)Yt = ut. Ifwe set (1-L) = 0, we obtain, L = 1, hence the nameunit root. Thus, the terms nonstationarity, randomwalk, and unit root can be treated as synonymous. If, however, ρ ≤ 1, that is if the absolute valueof ρ is less than one, then it can be shown that thetime series Yt is stationary.2.4 Illustrative ExamplesConsider the AR(1) model as presented in equation (6).Generally, we can have three possible cases:Case 1: ρ < 1 and therefore the series Yt is stationary. A graph of a stationary series for ρ = 0.67 is presented in Figure 4.Case 2: ρ > 1 where in this case the series explodes. A graph of an explosive series for ρ = 1.26 is presented in Figure 5. 14
- 15. Case 3: ρ = 1 where in this case the series contains a unit root and is non-stationary. Graph of stationary series for ρ = 1 are presented in Figure 6.In order to reproduce the graphs and the series whichare stationary, exploding and nonstationary, we typethe following commands in Eviews:Step 1: Open a new workfile (say, undated type),containing 200 observations.Step 2: Generate X, Y, Z as the following commands: smpl 1 1 genr X=0 genr Y=0 genr Z=0 smpl 2 200 genr X=0.67*X(-1)+nrnd genr Y=1.26*Y(-1)+nrnd genr Z=Z(-1)+nrnd smpl 1 200Step 3: Plot X, Y, Z using the line plot type (Figure4, 5, and 6). plot X plot Y plot Z 15
- 16. Figure 4: Stationary series 5 4 3 2 1 0 -1 -2 -3 -4 25 50 75 100 125 150 175 200Figure 5: Explosive series 1.6E+19 1.4E+19 1.2E+19 1.0E+19 8.0E+18 6.0E+18 4.0E+18 2.0E+18 0.0E+00 25 50 75 100 125 150 175 200 16
- 17. Figure 6: Nonstationary series 5 0 -5 -10 -15 -20 -25 25 50 75 100 125 150 175 2003. UNIT ROOTS AND SPURIOUS REGRESSIONS3.1 Spurious RegressionsMost macroeconomic time series are trended andtherefore in most cases are nonstationary (see forexamples time plots of imports, exports, money supply,FDI, GDP, CPI, market interest rates, and so on forthe Vietnam economy12). The problem with nonstationaryor trended data is that the standard ordinary leastsquares (OLS) regression procedures can easily lead toincorrect conclusions. According to Asteriou (2007),it can be shown in these cases that the regressionresults have very high value of R2 (sometimes evenhigher than 0.95) and very high values of t-ratios12 These data are now available at the H library. 17
- 18. (sometimes even higher than 4), while the variablesused in the analysis have no real interrelationships. Asteriou (2007) states that many economic seriestypically have an underlying rate of growth, which mayor may not be constant, for example GDP, prices ormoney supply all tend to grow at a regular annualrate. Such series are not stationary as the mean iscontinually rising however they are also notintegrated as no amount of differencing can make themstationary. This gives rise to one of the main reasonsfor taking the logarithm of data before subjecting itto formal econometric analysis. If we take thelogarithm of a series, which exhibits an averagegrowth rate we will turn it into a series whichfollows a linear trend and which is integrated. Thiscan be easily seen formally. Suppose we have a seriesXt, which increases by 10% every period, thus: Xt = 1.1Xt-1If we then take the logarithm of this we get log(Xt) = log(1.1) + log(Xt-1)Now the lagged dependent variable has a unitcoefficient and each period it increases by anabsolute amount equal to log(1.1), which is of courseconstant. This series would now be I(1)13. More formally, consider the model: Yt = β1 + β2Xt + ut (7)13 See Gujarati (2003: 804-806) 18
- 19. where ut is the error term. The assumptions ofclassical linear regression model (CLRM) require bothYt and Xt to have zero and constant variance (i.e., tobe stationary). In the presence of nonstationarity,then the results obtained from a regression of thiskind are totally spurious14 and these regressions arecalled spurious regressions. The intuition behind this is quite simple. Overtime, we expect any nonstationary series to wanderaround (see Figure 7), so over any reasonably longsample the series either drift up or down. If we thenconsider two completely unrelated series which areboth nonstationary, we would expect that either theywill both go up or down together, or one will go upwhile the other goes down. If we then performed aregression of one series on the other, we would thenfind either a significant positive relationship ifthey are going in the same direction or a significantnegative one if they are going in opposite directionseven though really they are both unrelated. This isthe essence of a spurious regression. It is said that a spurious regression usually has avery high R2 , t statistics that appear to providesignificant estimates, but the results may have noeconomic meaning. This is because the OLS estimatesmay not be consistent, and therefore the tests ofstatistical inference are not valid.14 This was first introduced by Yule (1926), and re-examined by Granger and Newbold (1974) using theMonte Carlo simulations. 19
- 20. Granger and Newbold (1974) constructed a Monte Carloanalysis generating a large number of Yt and Xt seriescontaining unit roots following the formulas: Yt = Yt-1 + eYt (8) Xt = Xt-1 + eXt (9)where eYt and eXt are artificially generated normalrandom numbers. Since Yt and Xt are independent of each other, anyregression between them should give insignificantresults. However, when they regressed the various Ytsto the Xts as show in equation (8), they surprisinglyfound that they were unable to reject the nullhypothesis of β2 = 0 for approximately 75% of theircases. They also found that their regressions had veryhigh R2s and very low values of DW statistics. To see the spurious regression problem, we can typethe following commands in Eviews (after opening thenew workfile, say, undated with 500 observations) tosee how many times we can reject the null hypothesisof β2 = 0. The commands are: smpl @first @first+1 (or smpl 1 1) genr Y=0 genr X=0 smpl @first+1 @last (or smpl 2 500) genr Y=Y(-1)+nrnd genr X=X(-1)+nrnd scat(r) Y X smpl @first @last 20
- 21. ls Y c XAn example of a scatter plot of Y against X obtainedin this way is shown in Figure 7. The estimatedequation is: Figure 7: Scatter plot of a spurious regression 10 0 -10 -20 Y -30 -40 -50 -10 -5 0 5 10 15 20 25 X 21
- 22. Granger and Newbold (1974) proposed the following“rule of thumb” for detecting spurious regressions: IfR2 > DW statistic or if R2 ≈ 1 then the regression‘must’ be spurious. To understand the problem of spurious regressionbetter, it might be useful to use an example with realeconomic data. This example was conducted by Asteriou(2007). Consider a regression of the logarithm of realGDP (Yt) to the logarithm of real money supply (Mt) anda constant. The results obtained from such aregression are the following: Yt = 0.042 + 0.453Mt; R2 = 0.945; DW = 0.221 (4.743) (8.572)Here we see very good t-ratios, with coefficients thathave the right signs and more or less plausiblemagnitudes. The coefficient of determination is veryhigh (R2 = 0.945), but there is a high degree ofautocorrelation (DW = 0.221). This shows evidence ofthe possible existence of spurious regression. Infact, this regression is totally meaningless becausethe money supply data are for the UK economy and theGDP figures are for the US economy. Therefore,although there should not be any significantrelationship, the regression seems to fit the datavery well, and this happens because the variables usedin the example are, simply, trended (nonstationary).So, Asteriou (2007) recommends that econometriciansshould be very careful when working with trendedvariables. 22
- 23. 3.2 Explaining the Spurious Regression ProblemAccording to Asteriou (2007), in a slightly moreformal way the source of the spurious regressionproblem comes from the fact that if two variables, Xand Y, are both stationary, then in general any linearcombination of them will certainly be stationary. Oneimportant linear combination of them is of course theequation error, and so if both variables arestationary, the error in the equation will also bestationary and have a well-behaved distribution.However, when the variables become nonstationary, thenof course we can not guarantee that the errors will bestationary and in fact as a general rule (although notalways) the error itself be nonstationary and whenthis happens, we violate the basic CLRM assumptions ofOLS regression. If the errors were nonstationary, wewould expect them to wander around and eventually getlarge. But OLS regression because it selects theparameters so as to make the sum of the squared errorsas small as possible will select any parameter whichgives the smallest error and so almost any parametervalue can result. The simplest way to examine the behaviour of ut isto rewrite (7) as: ut = Yt – β1 – β2Xt (10)or, excluding the constant β1 (which only affects utsequence by rescaling it): ut = Yt – β2Xt (11) 23
- 24. If Yt and Xt are generated by equations (8) and (9),then if we impose the initial conditions Y0 = X0 = 0 weget that: u t = Y0 + e Ý1 + e Ý 2 + ... + e Ýi + β 2 (X 0 + e X1 + e X 2 + ... + e Xi )or t t u t = ∑ e Yi + β 2 ∑ e Xi (12) i =1 i =1From equation (12), we realize that the variance ofthe error term will tend to become infinitely large ast increases. Hence, the assumptions of the CLRM areviolated, and therefore, any t test, F test or R2 areunreliable. In terms of equation (7), there are four differentcases to discuss:Case 1: Both Yt and Xt are stationary, and the CLRM is appropriate with OLS estimates being BLUE.Case 2: Yt and Xt are integrated of different orders15. In this case, the regression equations are meaningless.Case 3: Yt and Xt are integrated of the same order and the ut sequence contains a stochastic trend. In this case, we have spurious regression and it is often recommended to re-estimate the regression equation in the first differences or to re-specify it (usually by using the GLS method, such as Orcutt-Cochrane procedure)16.15 Denoted as I(d).16 See Nguyen Trong Hoai et al, 2009. 24
- 25. Case 4: Yt and Xt are integrated of the same order and the ut is stationary. In this special case, Yt and Xt are said to be cointegrated. This will be examined in detail later.4. TESTING FOR UNIT ROOTS4.1 Graphical AnalysisAccording to Gujarati (2003), before one pursuesformal tests, it is always advisable to plot the timeseries under study. Such a plot gives an initial clueabout the likely nature of the time series. Such aintuitive feel is the starting point of formal testsof stationary. If you use Eviews to support your study, you caneasily instruct yourself by the Help function:Help/Users Guide I (pdf)17.4.2 Autocorrelation Function and CorrelogramAutocorrelation is the correlation between a variablelagged one or more periods and itself. The correlogramor autocorrelation function is a graph of theautocorrelations for various lags of a time seriesdata. According to Hanke (2005), the autocorrelationcoefficients18 for different time lags for a variablecan be used to answer the following questions: 1. Are the data random? (This is usually used for the diagnostic tests of forecasting models).17 It is possible to read Nguyen Trong Hoai et al, 2009.18 This is not shown in this lecture. You can make references from Gujarati (2003: 808-813), Hanke(2005: 60-74), or Nguyen Trong Hoai et al (2009: Chapter 3, 4, and 8). 25
- 26. 2. Do the data have a trend (nonstationary)? 3. Are the data stationary? 4. Are the data seasonal?Besides, this is very useful when selecting theappropriate p and q in the ARIMA models19. If a series is random, the autocorrelations between Yt and Yt-k for any lag k are close to zero. The successive values of a time series are not related to each other (Figure 8). If a series has a trend, successive observations are highly correlated, and the autocorrelation coefficients are typically significantly different from zero for the first several time lags and then gradually drop toward zero as the number of lags increases. The autocorrelation coefficient for time lag 1 is often very large (close to 1). The autocorrelation coefficient for time lag 2 will also be large. However, it will not be as large as for time lag 1 (Figure 9). If a series is stationary, the autocorrelation coefficients for lag 1 or lag 2 are significantly different from zero and then suddenly die out as the number of lags increases (Figure 10). If a series has a seasonal pattern, a significant autocorrelation coefficient will occur at the seasonal time lag or multiples of seasonal lag (Figure 11). This is not important within this lecture context.19 See Nguyen Trong Hoai et al, 2009. 26
- 27. Figure 8: Correlogram of a random seriesFigure 9: Correlogram of a nonstationary seriesFigure 10: Correlogram of a stationary series 27
- 28. Figure 11: Correlogram of a seasonal seriesThe correlogram becomes very useful for time seriesforecasting and other practical (business)implications. If you conduct academic studies,however, it is necessary to provide some formalstatistics such as t statistic, Box-Pierce Qstatistic, Ljung-Box (LB) statistic, or especiallyunit root tests.4.3 Simple Dickey-Fuller Test for Unit RootsDickey and Fuller (1979,1981) devised a procedure toformally test for nonstationarity (hereafter refer toDF test). The key insight of their test is thattesting for nonstationarity is equivalent to testingfor the existence of a unit root. Thus the obvioustest is the following which is based on the simpleAR(1) model of the form: Yt = ρYt-1 + ut (13)What we need to examine here is ρ = 1 (unity and hence‘unit root’). Obviously, the null hypothesis is H0: ρ =1, and the alternative hypothesis is H1: ρ < 1 (why?). 28
- 29. We obtain a different (more convenient) version ofthe test by subtracting Yt-1 from both sides of (13): Yt – Yt-1 = ρYt-1 – Yt-1 + ut ∆Yt = (ρ - 1)Yt-1 + ut ∆Yt = δYt-1 + ut (14)where δ = (ρ - 1). Then, now the null hypothesis is H0:δ = 0, and the alternative hypothesis is H1: δ < 0(why?). In this case, if δ = 0, then Yt follows a purerandom walk. Dickey and Fuller (1979) also proposed twoalternative regression equations that can be used fortesting for the presence of a unit root. The firstcontains a constant in the random walk process as inthe following equation: ∆Yt = α + δYt-1 + ut (15)According to Asteriou (2007), this is an extremelyimportant case, because such processes exhibit adefinite trend in the series when δ = 0, which isoften the case for macroeconomic variables. The second case is also allow, a non-stochastic timetrend in the model, so as to have: ∆Yt = α + γT + δYt-1 + ut (16)The Dickey-Fuller test for stationarity is the simplythe normal ‘t’ test on the coefficient of the laggeddependent variable Yt-1 from one of the three models(14, 15, and 16). This test does not however have aconventional ‘t’ distribution and so we must use 29
- 30. special critical values which were originallycalculated by Dickey and Fuller. MacKinnon (1991,1996) tabulated appropriate criticalvalues for each of the three above models and theseare presented in Table 1. Table 1: Critical values for DF test Model 1% 5% 10%∆Yt = δYt-1 + ut -2.56 -1.94 -1.62∆Yt = α + δYt-1 + ut -3.43 -2.86 -2.57∆Yt = α + γT + δYt-1 + ut -3.96 -3.41 -3.13Standard critical values -2.33 -1.65 -1.28Source: Asteriou (2007)In all cases, the test concerns whether δ = 0. The DFtest statistic is the t statistic for the laggeddependent variable. If the DF statistical value issmaller in absolute terms than the critical value thenwe reject the null hypothesis of a unit root andconclude that Yt is a stationary process.4.4 Augmented Dickey-Fuller Test for Unit RootsAs the error term is unlikely to be white noise,Dickey and Fuller extended their test proceduresuggesting an augmented version of the test (hereafterrefer to ADF test) which includes extra lagged termsof the dependent variable in order to eliminate 30
- 31. autocorrelation. The lag length20 on these extra termsis either determined by Akaike Information Criterion(AIC) or Schwarz Bayesian/Information Criterion (SBC,SIC), or more usefully by the lag length necessary towhiten the residuals (i.e., after each case, we checkwhether the residuals of the ADF regression areautocorrelated or not through LM tests and not the DWtest (why?)). The three possible forms of the ADF test are givenby the following equations: p ∆Yt = δYt −1 + ∑ β i ∆Yt − i + u t (17) i =1 p ∆Yt = α + δYt −1 + ∑ β i ∆Yt −i + u t (18) i =1 p ∆Yt = α + γT + δYt −1 + ∑ β i ∆Yt −i + u t (19) i =1The difference between the three regressions concernsthe presence of the deterministic elements α and γT.The critical values for the ADF test are the same asthose given in Table 1 for the DF test. According to Asteriou (2007), unless theeconometrician knows the actual data-generatingprocess, there is a question concerning whether it ismost appropriate to estimate (17), (18), or (19).Daldado, Jenkinson and Sosvilla-Rivero (1990) suggesta procedure which starts from estimation of the mostgeneral model given by (19) and then answering a setof questions regarding the appropriateness of each20 Will be discussed later in this lecture. 31
- 32. model and moving to the next model. This procedure isillustrated in Figure 12. It needs to be stressed herethat, although useful, this procedure is not designedto be applied in a mechanical fashion. Plotting thedata and observing the graph is sometimes very usefulbecause it can clearly indicate the presence or not ofdeterministic regressors. However, this procedure isthe most sensible way to test for unit roots when theform of the data-generating process is unknown. In practical studies, researchers use both the ADFand the Phillips-Perron (PP) tests21. Because thedistribution theory that supporting the Dickey-Fullertests is based on the assumption of random error terms[iid(0,σ2)], when using the ADF methodology we have tomake sure that the error terms are uncorrelated andthey really have a constant variance. Phillips andPerron (1988) developed a generalization of the ADFtest procedure that allows for fairly mild assumptionsconcerning the distribution of errors. The regressionfor the PP test is similar to equation (15). ∆Yt = α + δYt-1 + et (20)While the ADF test corrects for higher order serialcorrelation by adding lagged differenced terms on theright-hand side of the test equation, the PP testmakes a correction to the t statistic of thecoefficient δ from the AR(1) regression to account forthe serial correlation in et.21 Eviews has a specific command for these tests. 32
- 33. Figure 12: Procedure for testing for unit roots Estimate the model p ∆Yt = α + γT + δYt −1 + ∑ β i ∆Yt −i + u t i =1 NO STOP: Conclude δ = 0? that there is no unit root YES: Test for the presence of the trend NO is γ = 0? NO STOP: Conclude given that δ = 0? that Yt has a YES δ = 0? unit root YES Estimate the model STOP: Conclude p NO ∆Yt = α + δYt −1 + ∑ β i ∆Yt −i + u t that there is no i =1 unit root is δ = 0? YES: Test for the NO presence of the constant is α = 0? NO STOP: Conclude given that δ = 0? that Yt has a YES δ = 0? unit root YES STOP: Conclude that there is no Estimate the model NO unit root p ∆Yt = δYt −1 + ∑ β i ∆Yt −i + u t i =1 is δ = 0? YES STOP: Conclude that Yt has a unit rootSource: Asteriou (2007) 33
- 34. So, the PP statistics are just modifications of theADF t statistics that take into account the lessrestrictive nature of the error process. Theexpressions are extremely complex to derive and arebeyond the scope of this lecture. However, since manystatistical packages (one of them is Eviews) haveroutines available to calculate these statistics, itis good for researcher/analyst to test the order ofintegration of a series performing the PP test aswell. The asymptotic distribution of the PP tstatistic is the same as the ADF t statistic andtherefore the MacKinnon (1991,1996) critical valuesare still applicable. As with the ADF test, the PPtest can be performed with the inclusion of a constantand linear trend, or neither in the test regression.4.5 Performing Unit Root Tests in Eviews4.5.1 The DF and ADF testStep 1 Open the file ADF.wf1 by clicking File/Open/Workfile and then choosing the file name from the appropriate path (You can open this file differently depending on how much you are familiar with Eviews).Step 2 Let’s assume that we want to examine whether the series named GDP contains a unit root. Double click on the series named ‘GDP’ to open the series window and choose View/Unit Root Test … (You can perform differently depending on how much you are familiar with Eviews). In the unit-root test dialog box that appears, choose the type test (i.e., the Augmented Dickey-Fuller test) by clicking on it.Step 3 We then specify whether we want to test for a unit root in the level, first difference, or second difference of the series. We can use 34
- 35. this option to determine the number of unit roots in the series. However, we usually start with the level and if we fail to reject the test in levels we continue with testing the first difference and so on. This becomes easier after you are performing some practices.Step 4 We also have to specify which model of the three ADF models we wish to use (i.e., whether to include a constant, a constant and linear trend, or neither in the test regression). For the model given by equation (17) click on ‘none’ in the dialog box; for the model given by equation (18) click on ‘intercept’ in the dialog box; and for the model given by equation (19) click on ‘intercept and trend’ in the dialog box;Step 5 Finally, we have to specify the number of lagged dependent variables to be included in the model in order to correct the presence of serial correlation. In practice, we just click the ‘automatic selection’ on the ‘lag length’ dialog box.Step 6 Having specified these options, click <OK> to carry out the test. Eviews reports the test statistic together with the estimated test regression.Step 7 We reject the null hypothesis of a unit root against the one-sided alternative if the ADF statistic is less than (lies to the left of) the critical value, and we conclude that the series is stationary.Step 8 After running a unit root test, we should examine the estimated test regression reported by Eviews, especially if unsure about the lag structure or deterministic trend in the series. We may want to rerun the test equation with a different selection of right-hand variables (add or delete the constant, trend, or lagged differences) or lag order.Source: Asteriou (2007) 35
- 36. Figure 13: Illustrative steps in Eviews (ADF) This figure is positive, so the selected model is incorrect (see Gujarati (2003)). 36
- 37. 4.5.2 The PP test Step 1 Open the file PP.wf1 by clicking File/Open/Workfile and then choosing the file name from the appropriate path (You can open this file differently depending on how much you are familiar with Eviews). Step 2 Let’s assume that we want to examine whether the series named GDP contains a unit root. Double click on the series named ‘GDP’ to open the series window and choose View/Unit Root Test … (You can perform differently depending on how much you are familiar with Eviews). In the unit-root test dialog box that appears, choose the type test (i.e., the Phillipd-Perron test) by clicking on it. Step 3 We then specify whether we want to test for a unit root in the level, first difference, or second difference of the series. We can use this option to determine the number of unit roots in the series. However, we usually start with the level and if we fail to reject the test in levels we continue with testing the first difference and so on. This becomes easier after you are performing some practices. Step 4 We also have to specify which model of the three we need to use (i.e., whether to include a constant, a constant and linear trend, or neither in the test regression). For the random walk model click on ‘none’ in the dialog box; for the random with drift model click on ‘intercept’ in the dialog box; and for the random walk with drift and with deterministic trend model click on ‘intercept and trend’ in the dialog box. Step 5 Finally, for the PP test we specify the lag truncation to compute the Newey-West heteroskedasticity and autocorrelation (HAV)22 consistent estimate of the spectrum at zero22 This is already mentioned in the Basic Econometrics course, Serial Correlation topic. 37
- 38. frequency.Step 6 Having specified these options, click <OK> to carry out the test. Eviews reports the test statistic together with the estimated test regression.Step 7 We reject the null hypothesis of a unit root against the one-sided alternative if the ADF statistic is less than (lies to the left of) the critical value, and we conclude that the series is stationary.Source: Asteriou (2007) Figure 14: Illustrative steps in Eviews (PP) This figure is positive, so the selected model is incorrect (see Gujarati (2003)). 38
- 39. 5. VECTOR AUTOREGRESSIVE MODELSAccording to Asteriou (2007), it is quite common ineconomics to have models where some variables are notonly explanatory variables for a given dependentvariable, but they are also explained by the variablesthat they are used to determine. In those cases, wehave models of simultaneous equations, in which it isnecessary to clearly identify which are the endogenousand which are the exogenous or predeterminedvariables. The decision regarding such adifferentiation among variables was heavily criticizedby Sims (1980). According to Sims (1980), if there is simultaneityamong a number of variables, then all these variablesshould be treated in the same way. In other words,these should be no distinction between endogenous andexogenous variables. Therefore, once this distinctionis abandoned, all variables are treated as endogenous.This means that in its general reduced form, eachequation has the same set of regressors which leads tothe development of the VAR models. The VAR model is defined as follow. Suppose we havetwo series, in which Yt is affected by not only itspast values but current and past values of Xt, andsimultaneously, Xt is affected by not only its pastvalues but current and past values of Yt. This simplebivariate VAR model is given by: Yt = β10 - β12Xt + γ11Yt-1 + γ12Xt-1 + uyt (21) Xt = β20 - β21Yt + γ21Yt-1 + γ22Xt-1 + uxt (22) 39
- 40. where we assume that both Yt and Xt are stationary anduyt and uxt are uncorrelated white-noise error terms.These equations are not reduced-form equations sinceYt has a contemporaneous impact on Xt, and Xt has acontemporaneous impact on Yt. The illustrative exampleis presented in Figure 15 (open the file VAR.wf1). Figure 15: An illustration of VAR in Eviews Vector Autoregression Estimates Date: 02/20/10 Time: 15:46 Sample (adjusted): 1975Q3 1997Q4 Included observations: 90 after adjustments Standard errors in ( ) & t-statistics in [ ] GDP M2 GDP(-1) 1.230362 -0.071108 (0.10485) (0.09919) [11.7342] [-0.71691] GDP(-2) -0.248704 0.069167 (0.10283) (0.09728) [-2.41850] [0.71103] M2(-1) 0.142726 1.208942 (0.11304) (0.10693) 40
- 41. [1.26267] [11.3063] M2(-2) -0.087270 -0.206244 (0.11599) (0.10972) [-0.75237] [-1.87964] C 4.339620 8.659425 (3.02420) (2.86077) [1.43497] [3.02696] R-squared 0.999797 0.998967 Adj. R-squared 0.999787 0.998918 Sum sq. resids 6000.811 5369.752 S.E. equation 8.402248 7.948179 F-statistic 104555.2 20543.89 Log likelihood -316.6973 -311.6972 Akaike AIC 7.148828 7.037716 Schwarz SC 7.287707 7.176594 Mean dependent 967.0556 509.1067 S.D. dependent 576.0331 241.6398 Determinant resid covariance 4459.738 Determinant resid covariance 3977.976 Log likelihood -628.3927 Akaike information criterion 14.18650 Schwarz criterion 14.46426According to Asteriou (2007), the VAR model has somegood characteristics. First, it is very simple becausewe do not have to worry about which variables areendogenous or exogenous. Second, estimation is verysimple as well, in the sense that each equation can beestimated with the usual OLS method separately. Third,forecasts obtained from VAR models are in most casesbetter than those obtained from the far more complexsimultaneous equation models (see Mahmoud, 1984;McNees, 1986). Besides forecasting purposes, VARmodels also provide framework for causality tests,which will be presented shortly in the next section. However, on the other hand the VAR models have facedsevere criticism on various different points. 41
- 42. According to Asteriou (2007), the VAR models have beencriticised by the following aspects. First, they area-theoretic since they are not based on any economictheory. Since initially there are no restrictions onany of the parameters under estimation, in effect‘everything causes everything’. However, statisticalinference is often used in the estimated models sothat some coefficients that appear to be insignificantcan be dropped, in order to lead models that mighthave an underlying consistent theory. Such inferenceis normally carried out using what are calledcausality tests. Second, they are criticised due tothe loss of degrees of freedom. Thus, if the samplesize is not sufficiently large, estimating that largea number of parameters, say, a three-variable VARmodel with 12 lags for each, will consume many degreesof freedom, creating problems in estimation. Third,the obtained coefficients of the VAR models aredifficult to interpret since they totally lack anytheoretical background. If you are interested in VAR models, you can findadditional readings from the econometrics textbooksabout time series data, listed in the references ofthis lecture.6. CAUSALITY TESTSAccording to Asteriou (2007), one of the good featuresof VAR models is that they allow us to test thedirection of causality. Causality in econometrics issomewhat different to the concept in everyday use 42
- 43. (take examples?); it refers more to the ability of onevariable to predict (and therefore cause) the other. Suppose two stationary variables, say Yt and Xt,affect each other with distributed lags. Therelationship between Yt and Xt can be captured by a VARmodel. In this case, it is possible to have that (a)Yt causes Xt, (b) Xt causes Yt, (c) there is a bi-directional feedback (causality among the variables),and finally (d) the two variables are independent. Theproblem is to find an appropriate procedure thatallows us to test and statistically detect the causeand effect relationship among variables. Granger (1969) developed a relatively simple testthat defined causality as follows: a variable Yt issaid to Granger-cause Xt, if Xt can be predicted withgreater accuracy by using past values of the Ytvariable rather than not using such past values, allother terms remaining unchanged. This test has beenwidely applied in economic policy analysis.6.1 The Granger Causality TestThe Granger causality test for the of two stationaryvariables Yt and Xt , involves as a first step theestimation of the following VAR model: n m Yt = α + ∑ β i Yt −i + ∑ γ j X t − j + u yt (23) i =1 j=1 n m X t = α + ∑ θ i X t −i + ∑ δ j Yt − j + u xt (24) i =1 j=1where it is assumed that both uyt and uxt areuncorrelated white-noise error terms. In this model,we can have the following different cases: 43
- 44. Case 1 The lagged X terms in equation (23) are statistically different from zero as a group, and the lagged Y terms in equation (24) are not statistically different from zero. In this case, we have that Xt causes Yt.Case 2 The lagged Y terms in equation (24) are statistically different from zero as a group, and the lagged X terms in equation (23) are not statistically different from zero. In this case, we have that Yt causes Xt.Case 3 Both sets of X and Y terms are statistically different from zero as a group in equation (23) and equation (24), so that we have bi- directional causality.Case 4 Both sets of X and Y terms are not statistically different from zero in equation (23) and equation (24), so that Xt is independent of Yt.The Granger causality test, then, involves thefollowing procedures. First, estimate the VAR modelgiven by equations (23) and (24). Then check thesignificance of the coefficients and apply variabledeletion tests first in the lagged X terms forequation (23), and then in the lagged Y terms inequation (24). According to the result of the variabledeletion tests, we may conclude about the direction ofcausality based upon the four cases mentioned above. More analytically, and for the case of one equation(i.e., we will examine equation (23)), it is intuitive 44
- 45. to reverse the procedure in order to test for equation(24), and we perform the following steps:Step 1 Regress Yt on lagged Y terms as in the following model: n Yt = α + ∑ β i Yt − j + u yt (25) i =1 and obtain the RSS of this regression (which is the restricted one) and label it as RSSR.Step 2 Regress Yt on lagged Y terms plus lagged X terms as in the following model: n m Yt = α + ∑ β i Yt −i + ∑ γ j X t − j + u yt (26) i =1 j=1 and obtain the RSS of this regression (which is the unrestricted one) and label it as RSSU.Step 3 Set the null and alternative hypotheses as below: m H0 : ∑γ j=1 j = 0 or X t does not cause Yt m H1 : ∑γ j=1 j ≠ 0 or X t does cause YtStep 4 Calculate the F statistic for the normal Wald test on coefficient restrictions given by: (RSS R − RSS U ) / m F= RSS u /( N − k ) where N is the included observations and k = m+n+1 is the number of estimated coefficients in the unrestricted model.Step 5 If the computed F value exceeds the critical F value, reject the null hypothesis and conclude that Xt causes Yt. 45
- 46. Open the file GRANGER.wf1 and then perform as follows: Figure 16: An illustration of GRANGER in Eviews23Why I use the first differenced series?23 However, this is not a good way of conducting Granger causality test (why?) 46
- 47. Note that this ‘lag specification’ is not highlyappreciated in empirical studies (why?).How do you explain this test results?6.2 The Sims Causality TestSims (1980) proposed an alternative test for causalitymaking use of the fact that in any general notion ofcausality, it is not possible for the future to causethe present. Therefore, when we want to check whethera variable Yt causes Xt, Sims suggests estimating thefollowing VAR model: n m k Yt = α + ∑ β i Yt −i + ∑ γ j X t − j + ∑ ηρ X t +ρ + u yt (27) i =1 j=1 ρ =1 n m k X t = α + ∑ θ i X t −i + ∑ δ j Yt − j + ∑ λ ρ Yt +ρ + u xt (28) i =1 j=1 ρ =1The new approach here is that apart from lagged valuesof X and Y, there are also leading values of Xincluded in the first equation (and similarly leadingvalues of Y in the second equation). Examining only the first equation, if Yt causes Xt,then we will expect that there is some relationship 47
- 48. between Y and the leading values of X. Therefore,instead of testing for the lagged values of Xt, we ∑ ktest for ρ =1 ηρ = 0 . Note that if we reject therestriction, then the causality runs from Yt to Xt, andnot vice versa, since the future cannot cause thepresent. To carry out the test, we simply estimate a modelwith no leading terms (which is the restricted model)and then the model as appears in (27), which is theunrestricted model, and the obtain the F statistic asin the Granger test above. It is unclear which version of the two tests ispreferable, and most researchers use both. The Simstest, however, using more regressors (due to theinclusion of the leading terms), leads to a biggerloss of degrees of freedom.7. COINTEGRATION AND ERROR CORRECTION MODELS7.1 CointegrationAccording to Asteriou (2007), the concept ofcointegration was first introduced by Granger (1981)and elaborated further Engle and Granger (1987), Engleand Yoo (1987), Phillips and Ouliaris (1990), Stockand Watson (1988), Phillips (1986 and 1987), andJohansen (1988, 1991, and 1995). It is known that trended time series can potentiallycreate major problems in empirical econometrics due tospurious regressions. One way of resolving this is todifference the series successively until stationary isachieved and then use the stationary series forregression analysis. According to Asteriou (2007), 48
- 49. this solution, however, is not ideal because it notonly differences the error process in the regression,but also no longer gives a unique long-run solution. If two variables are nonstationary, then we canrepresent the error as a combination of two cumulatederror process. These cumulated error processes areoften called stochastic trends and normally we couldexpect that they would combine to produce another non-stationary process. However, in the special case thattwo variables, say X and Y, are really related, thenwe would expect them to move together and so the twostochastic trends would be very similar to each otherand when we combine them together it should bepossible to find a combination of them whicheliminates the nonstationarity. In this special case,we say that the variables are cointegrated (Asteriou,2007). Cointegration becomes an overriding requirementfor any economic model using nonstationary time seriesdata. If the variables do not co-integrate, we usuallyface the problems of spurious regression andeconometric work becomes almost meaningless. On theother hand, if the stochastic trends do cancel to eachother, then we have cointegration. Suppose that, if there really is a genuine long-runrelationship between Yt and Xt , the although thevariables will rise overtime (because they aretrended), there will be a common trend that links themtogether. For an equilibrium, or long-run relationshipto exist, what we require, then, is a linearcombination of Yt and Xt that is a stationary variable(an I(0) variable). A linear combination of Yt and Xt 49
- 50. can be directly taken from estimating the followingregression: Yt = β1 + β2Xt + ut (29)And taking the residuals: u t = Yt − β1 − β 2 X t ˆ ˆ ˆ (30) ˆIf u t ~ I(0), then the variables Yt and Xt are said tobe co-integrated. Importantly, based on the previous studies, we candraw the general procedure for nonstationary seriesanalysis as follows: (1) If (two) nonstationary variables are integrated of the same order, but not co-integrated, we should apply VAR models for the differenced series. These models just provide short-run relationships between them. This is widely called the “Standard version of Granger causality” (Section 6.1). (2) If (two) nonstationary variables are integrated of the same order, and co-integrated, we cannot apply the standard Granger causality test. The existence of co-integrating relationships between variables suggests that there must be Granger causality in at least one direction. However, it does not indicate the direction of temporal causality between the variables. To determine the direction of causation, we must examine the error correction mechanism (ECM) model. The ECM enables us to distinguish between ‘short-run’ and ‘long-run’ Granger causality. This is widely known as the “Cointegration and Error Correction version of 50
- 51. Granger causality” (Section 7.2). We sometimes use the term ‘cointegration and error correction version of Granger causality’ and ECM interchangeably. (3) If (two) nonstationary variables are integrated of the different orders, or non-cointegrated or cointegrated of an arbitrary order, we cannot apply either the standard Granger causality test or the ECM. In these cases, it is often suggested to employ the “Toda and Yamamoto version of Granger causality”, or simply the Toda and Yamamoto methodology, using the modified Wald (MWALD) test statistic (see Mehrara, 2007). Another method is “Bounds Test for Cointegration within ARDL” developed by Pesaran et al. (2001) (see Katircioglu, 2009). However, these are beyond the scope of this lecture.7.2 Error Correction MechanismAccording to Asteriou (2007), the concepts ofcointegration and the error correction mechanism(hereafter refer to ECM) are very closely related. Tounderstand the ECM, it is better to think first of theECM as a convenient reparametrization of the generallinear autoregressive distributed lag (ARDL) model. Consider the very simple dynamic ARDL modeldescribing the behaviour of Y in terms of X asfollows: Yt = a0 + a1Yt-1 + γ0Xt + γ1Xt-1 + ut (31)where ut ~ iid(0,σ2). 51
- 52. In this model24, the parameter γ0 denotes the short-run reaction of Yt after a change in Xt. The long-runeffect is given when the model is in equilibriumwhere: Yt* = β 0 + β1 X * t (32)and for simplicity, we assume that: X * = X t = X t −1 = ... = X t − p t (33)From (31), (32), and (33), we have: Yt* = a 0 + a 1Yt* + γ 0 X * + γ 1X * + u t t t Yt* (1 − a 1 ) = a 0 + ( γ 0 + γ 1 )X * + u t t a0 γ + γ1 * Yt* = + 0 Xt + u t 1 − a1 1 − a1 Yt* = β 0 + β1 X * + u t t (34)Therefore, the long-run elasticity between Y and X iscaptured by β1=(γ0+γ1)/(1-a1). It is noted that, we needto make the assumption that a1 < 1 (why?) in orderthat the short-run model (31) converges to a long-runsolution. The ECM can be rewritten as follows: ∆Yt = γ0∆Xt – (1-a)[Yt-1 – β0 – β1Xt-1] + ut (35) ∆Yt = γ0∆Xt – π[Yt-1 – β0 – β1Xt-1] + ut (36)(please show that the ECM model (35) is the same asthe original model (31)?)24 We can easily expand this model to a more general case for large numbers of lagged terms. 52
- 53. According to Asteriou (2007), what is of importancehere is that when the two variables Y and X arecointegrated, the ECM incorporates not only short-runbut also long-run effects. This is because the long-run equilibrium Yt-1 – β0 – β1Xt-1 is included in themodel together with the short-run dynamics captured bythe differenced term. Another important advantage isthat all the terms in the ECM model are stationary(why?) and the standard OLS estimation is thereforevalid. This is because if Y and X are I(1), then ∆Ytand ∆Xt are I(0), and by definition if Y and X arecointegrated then their linear combination (Yt-1 – β0 –β1Xt-1) ~ I(0). A final important point is that the coefficient π =(1-a1) provides us with information about the speed ofadjustment in cases of disequilibrium. To understandthis better, consider the long-run condition. Whenequilibrium holds, then (Yt-1 – β0 – β1Xt-1) = 0.However, during periods of disequilibrium this term isno longer be zero and measures the distance the systemis away from equilibrium. For example, suppose thatdue to a series of negative shocks in the economy(captured by the error term ut), Yt starts to increaseless rapidly the is consistent with (34). This causes(Yt-1 – β0 – β1Xt-1) to be negative because Yt-1 has movedbelow its long-run steady-state growth path. However,since π = (1-a1) is positive (why?), the overall effectis to boost ∆Yt back towards its long-run path asdetermined by Xt in equation (34). The speed of thisadjustment to equilibrium is dependent upon themagnitude of π = (1-a1). 53
- 54. The coefficient π in equation (36) is the error-correction coefficient and is also called theadjustment coefficient. In fact, π tells us how muchof the adjustment to equilibrium takes place eachperiod, or how much of the equilibrium error iscorrected each period. According to Asteriou (2007),it can be explained in the following ways: 1. If π ~ 1, then nearly 100% of the adjustment takes place within the period25, or the adjustment is very fast. 2. If π ~ 0.5, then about 50% of the adjustment takes place each period. 3. If π ~ 0, then there seems to be no adjustment.According to Asteriou (2007), the ECM is important andpopular for many reasons: 1. Firstly, it is a convenient model measuring the correction from disequilibrium of the previous period which has a very good economic implication. 2. Secondly, if we have cointegration, ECM models are formulated in terms of first difference, which typically eliminate trends from the variables involved; they resolve the problem of spurious regressions. 3. A third very important advantage of ECM models is the ease with they can fit into the general-to- specific (or Hendry) approach to econometric25 Depending on the kind of data used, say, annually, quarterly, or monthly. 54
- 55. modeling, which is a search for the best ECM model that fits the given data sets. 4. Finally the fourth and most important feature of ECM comes from the fact that the disequilibrium error term is a stationary variable. Because of this, the ECM has important implications: the fact that the two variables are cointegrated implies that there is some automatically adjustment process which prevents the errors in the long-run relationship becoming larger and larger.7.3 Testing for Cointegration7.3.1 The Engle-Granger (EG) ApproachGranger (1981) introduced a remarkable link betweennonstationary processes and the concept of long-runequilibrium; this link is the concept ofcointegration. Engle and Granger (1987) furtherformulized this concept by introducing a very simpletest for the existence of co-integrating (i.e., long-run equilibrium) relationships. This method involves the following steps:Step 1 Test the variables for their order of integration. The first step is to test each variable to determine its order of integration. The Dickey-Fuller and the augmented Dickey- Fuller tests can be applied in order to infer the number of unit roots in each of the variables. We might face three cases: a) If both variables are stationary (I(0)), 55
- 56. it is not necessary to proceed since standard time series methods apply to stationary variables. b) If the variables are integrated of different orders, it is possible to conclude that they are not cointegrated. c) If both variables are integrated of the same order, we proceed with step two.Step 2 Estimate the long-run (possible co- integrating) relationship. If the results of step 1 indicate that both Xt and Yt are integrated of the same order (usually I(1)) in economics, the next step is to estimate the long-run equilibrium relationship of the form: Yt = β1 + β 2 X t + u t (37) and obtain the residuals of this equation. If there is no cointegration, the results obtained will be spurious. However, if the variables are cointegrated, OLS regression yields consistent estimators for the co- integrating parameter β 2 . ˆStep 3 Check for (cointegration) the order of integration of the residuals. In order to determine if the variables are actually cointegrated, denote the estimated residual sequence from the ˆ ˆ equation by u t . Thus, u t is the series of the estimated residuals of the long-run 56
- 57. relationship. If these deviations from long- run equilibrium are found to be stationary, the Xt and Yt are cointegrated.Step 4 Estimate the error correction model. If the variables are cointegrated, the residuals from the equilibrium regression can be used to estimate the error correction model and to analyse the long-run and short- run effects of the variables as well as to see the adjustment coefficient, which is the coefficient of the lagged residual terms of the long-run relationship identified in step 2. At the end, we always have to check for the accuracy of the model by performing diagnostic tests.Source: Asteriou (2007)According to Asteriou (2007), one of the best featuresof the EG approach is that it is both very easy tounderstand and to implement. However, there areimportant shortcomings of the EG approach. (1) One very important issue has to do with the order of the variables. When estimating the long-run relationship, one has to place one variable in the left-hand side and use the others as regressors. The test does not say anything about which of the variables can be used as regressors and why. Consider, for example, the case of just two variables, Xt and Yt. One can either regress Yt on Xt (i.e., Yt = a + βXt + u1t) or choose to reverse the order and 57
- 58. regress Xt on Yt (i.e., Xt = a + βYt + u2t). It can be shown, which asymptotic theory, that as the sample goes to infinity the test for cointegration on the residuals of those two regressions is equivalent (i.e., there is no difference in testing for unit roots in u1t and u2t). However, in practice, in economics we rarely have very big samples and it is therefore possible to find that one regression exhibits cointegration while the other doesn’t. This is obviously a very undesirable feature of the EG approach. The problem obviously becomes far more complicated when we have more than two variables to test.(2) A second problem is that when there are more than two variables there may be more than on integrating relationship, and EG approach using residuals from a single relationship can not treat this possibility. So, the most important problem is that it does not give us the number of co-integrating vectors.(3) A third and final problem is that it replies on a two-step estimator. The first step is to generate the residual series and the second step is to estimate a regression for this series in order to see if the series is stationary or not. Hence, any error introduced in the first step is carried into the second step. 58
- 59. The EG approach in EviewsThe EG test approach is very easy to perform and doesnot require any more knowledge regarding the use ofEviews. For the first step, ADF and PP tests on allvariables are needed to determine the order ofintegration of the variables. If the variables (let’ssay X and Y) are found to be integrated of the sameorder, then the second step involves estimating thelong-run relationship with simple OLS procedure. Sothe command here is simply: ls X c Y or ls Y c Xdepending on the relationship of the variables. Wethen need to obtain the residuals of this relationshipwhich are given by: genr res1=residThe third step (the actual test for cointegration) isa unit root test on the residuals, the command forwhich is: adf res1for no lags, or adf(4) res1for 4 lags in the augmentation term, and so on.7.3.2 The Johansen ApproachAccording to Asteriou (2007), if we have more than twovariables in the model, then there is a possibility ofhaving more than one co-integrating vector. By this we 59
- 60. mean that the variables in the model might formseveral equilibrium relationships. In general, for nnumber of variables, we can have only up to n-1 co-integrating vectors. Having n > 2 and assuming that only one co-integrating relationship exists, where there areactually more than one, is a very serious problem thatcannot be resolved by the EG single-equation approach.Therefore, an alternative to the EG approach is neededand this is the Johansen approach26 for multipleequations. In order to present this approach, it is useful toextend the single-equation error correction model to amultivariate one. Let’s assume that we have threevariables, Yt, Xt and Wt, which can all be endogenous,i.e., we have that (using matrix notation for Zt =[Yt,Xt,Wt]) Zt = A1Zt-1 + A2Zt-2 + … + AkZt-k + ut (37)which is comparable to the single-equation dynamicmodel for two variables Yt and Xt given in (31). Thus,it can be reformulated in a vector error correctionmodel (VECM) as follows: ∆Zt = Γ1∆Zt-1 + Γ2∆Zt-2 + … + Γk-1∆Zt-k-1 + ΠZt-1 + ut (38)where the matrix Π contains information regarding thelong-run relationships. We can decompose Π = αβ’ whereα will include the speed of adjustment to equilibrium26 For clearer, please read Li, X. (2001) ‘Government Revenue, Government Expenditure, and TemporalCausality: Evidence from China’, Applied Economics, Vol.33, pp.485-497. 60

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