CH 09

Chapter 9
Regression with Time Series Data:

Stationary Variables
Walter R. Paczkowski
Rutgers University
Chapter 9: Regression with Time Series Data:
Principles of Econometrics, 4th Edition Stationary Variables
Page 1
Chapter Contents
 9.1 Introduction
 9.2 Finite Distributed Lags
 9.3 Serial Correlation
 9.4 Other Tests for Serially Correlated Errors
 9.5 Estimation with Serially Correlated Errors
 9.6 Autoregressive Distributed Lag Models
 9.7 Forecasting
 9.8 Multiplier Analysis

Page 2
9.1
Introduction

Page 3
9.1
Introduction
When modeling relationships between variables,

the nature of the data that have been collected has
an important bearing on the appropriate choice of
an econometric model
– Two features of time-series data to consider:
1. Time-series observations on a given
economic unit, observed over a number of
time periods, are likely to be correlated
2. Time-series data have a natural ordering
according to time

Page 4
9.1
Introduction
There is also the possible existence of dynamic

relationships between variables
– A dynamic relationship is one in which the
change in a variable now has an impact on that
same variable, or other variables, in one or
more future time periods
– These effects do not occur instantaneously but
are spread, or distributed, over future time
periods

Page 5
9.1
Introduction FIGURE 9.1 The distributed lag effect

Page 6
9.1
Introduction
9.1.1
Dynamic Nature of
Relationships
Ways to model the dynamic relationship:
1. Specify that a dependent variable y is a
function of current and past values of an
explanatory variable x
Eq. 9.1 yt  f ( xt , xt 1, xt 2 ,...)
• Because of the existence of these lagged

effects, Eq. 9.1 is called a distributed lag
model

Page 7
9.1
Introduction
9.1.1
Dynamic Nature of Ways to model the dynamic relationship (Continued):
Relationships
2. Capturing the dynamic characteristics of time-
series by specifying a model with a lagged
dependent variable as one of the explanatory
variables
Eq. 9.2 yt  f ( yt 1 , xt )
• Or have:
Eq. 9.3 yt  f ( yt 1 , xt , xt 1 , xt 2 )
– Such models are called autoregressive
distributed lag (ARDL) models, with
‘‘autoregressive’’ meaning a regression of yt
on its own lag or lags
Page 8
9.1
Introduction
9.1.1
Dynamic Nature of
Relationships
Ways to model the dynamic relationship (Continued):
3. Model the continuing impact of change over
several periods via the error term
Eq. 9.4 yt  f ( xt )  et et  f (et 1 )
• In this case et is correlated with et - 1

• We say the errors are serially correlated or
autocorrelated

Page 9
9.1
Introduction
9.1.2
Least Squares
Assumptions
The primary assumption is Assumption MR4:
cov  yi , y j   cov  ei , e j   0 for i  j
• For time series, this is written as:
cov  yt , ys   cov  et , es   0 for t  s
– The dynamic models in Eqs. 9.2, 9.3 and 9.4

imply correlation between yt and yt - 1 or et and
et - 1 or both, so they clearly violate assumption
MR4

Page 10
9.1
Introduction
9.1.2a
Stationarity
A stationary variable is one that is not explosive,

nor trending, and nor wandering aimlessly without
returning to its mean

Page 11
9.1
Introduction FIGURE 9.2 (a) Time series of a stationary variable
9.1.2a
Stationarity

Page 12
9.1 FIGURE 9.2 (b) time series of a nonstationary variable that is ‘‘slow-turning’’
Introduction
or ‘‘wandering’’
9.1.2a
Stationarity

Page 13
9.1
Introduction FIGURE 9.2 (c) time series of a nonstationary variable that ‘‘trends”
9.1.2a
Stationarity

Page 14
9.1 FIGURE 9.3 (a) Alternative paths through the chapter starting with finite
Introduction
distributed lags
9.1.3
Alternative Paths
Through the
Chapter

Page 15
9.1 FIGURE 9.3 (b) Alternative paths through the chapter starting with
Introduction
serial correlation
9.1.3
Alternative Paths
Through the
Chapter

Page 16
9.2
Finite Distributed Lags

Page 17
9.2
Finite Distributed
Lags
Consider a linear model in which, after q time

periods, changes in x no longer have an impact on
y
Eq. 9.5 yt    0 xt  1 xt 1  2 xt 2   q xt q  et
– Note the notation change: βs is used to denote

the coefficient of xt-s and α is introduced to
denote the intercept

Page 18
9.2
Finite Distributed
Lags
Model 9.5 has two uses:

– Forecasting
Eq. 9.6 yT 1    0 xT 1  1 xT  2 xT 1   q xT q 1  eT 1
– Policy analysis
• What is the effect of a change in x on y?
E ( yt ) E ( yt  s )
Eq. 9.7   s
xt  s xt

Page 19
9.2
Finite Distributed
Lags
Assume xt is increased by one unit and then

maintained at its new level in subsequent periods
– The immediate impact will be β0
– the total effect in period t + 1 will be β0 + β1, in
period t + 2 it will be β0 + β1 + β2, and so on
• These quantities are called interim
multipliers
– The total multiplier is the final effect on y of
the sustained increase
q
after q or more periods
have elapsed  β s
s 0

Page 20
9.2
Finite Distributed
Lags
The effect of a one-unit change in xt is distributed

over the current and next q periods, from which
we get the term ‘‘distributed lag model’’
– It is called a finite distributed lag model of
order q
• It is assumed that after a finite number of
periods q, changes in x no longer have an
impact on y
– The coefficient βs is called a distributed-lag
weight or an s-period delay multiplier
– The coefficient β0 (s = 0) is called the impact
multiplier
Page 21
9.2
Finite Distributed ASSUMPTIONS OF THE DISTRIBUTED LAG MODEL
Lags
9.2.1
Assumptions
TSMR1. yt    β0 xt  β1 xt 1  β2 xt 2   βq xt q  et , t  q  1, , T
TSMR2. y and x are stationary random variables, and et is independent of
current, past and future values of x.
TSMR3. E(et) = 0
TSMR4. var(et) = σ2
TSMR5. cov(et, es) = 0 t ≠ s
TSMR6. et ~ N(0, σ2)

Page 22
9.2
Finite Distributed
Lags
9.2.2
An Example: Consider Okun’s Law
Okun’s Law
– In this model the change in the unemployment

rate from one period to the next depends on the
rate of growth of output in the economy:
Eq. 9.8 Ut  Ut 1    Gt  GN 
– We can rewrite this as:
Eq. 9.9 DUt    β0Gt  et
where DU = ΔU = Ut - Ut-1, β0 = -γ, and
α = γGN
Page 23
9.2
Finite Distributed
Lags
9.2.2
An Example:
Okun’s Law
We can expand this to include lags:
Eq. 9.10 DUt    β0Gt  β1Gt 1  β2Gt 2   βqGt q  et
We can calculate the growth in output, G, as:
GDPt  GDPt 1
Eq. 9.11 Gt  100
GDPt 1

Page 24
9.2
Finite Distributed
FIGURE 9.4 (a) Time series for the change in the U.S. unemployment rate:
Lags 1985Q3 to 2009Q3
9.2.2
An Example:
Okun’s Law

Page 25
9.2
Finite Distributed FIGURE 9.4 (b) Time series for U.S. GDP growth: 1985Q2 to 2009Q3
Lags
9.2.2
An Example:
Okun’s Law

Page 26
9.2
Finite Distributed Table 9.1 Spreadsheet of Observations for Distributed Lag Model
Lags
9.2.2
An Example:
Okun’s Law

Page 27
9.2
Finite Distributed Table 9.2 Estimates for Okun’s Law Finite Distributed Lag Model
Lags
9.2.2
An Example:
Okun’s Law

Page 28
9.3
Serial Correlation

Page 29
9.3
Serial Correlation
When is assumption TSMR5, cov(et, es) = 0 for

t ≠ s likely to be violated, and how do we assess
its validity?
– When a variable exhibits correlation over time,
we say it is autocorrelated or serially
correlated
• These terms are used interchangeably

Page 30
9.3
Serial Correlation FIGURE 9.5 Scatter diagram for Gt and Gt-1
9.3.1
Serial Correlation
in Output Growth

Page 31
9.3
Serial Correlation
9.3.1a
Computing
Autocorrelation
Recall that the population correlation between two

variables x and y is given by:
cov  x, y 
ρ xy 
var  x  var  y 

Page 32
9.3
Serial Correlation
9.3.1a
Computing For the Okun’s Law problem, we have:
Autocorrelation
cov  Gt , Gt 1  cov  Gt , Gt 1 
ρ1  
var  Gt  var  Gt 1  var  Gt 
Eq. 9.12
The notation ρ1 is used to denote the population

correlation between observations that are one period
apart in time
– This is known also as the population
autocorrelation of order one.
– The second equality in Eq. 9.12 holds because
var(Gt) = var(Gt-1) , a property of time series that
are stationary
Page 33
9.3
Serial Correlation
9.3.1a
Computing
Autocorrelation
The first-order sample autocorrelation for G is

obtained from Eq. 9.12 using the estimates:
cov  Gt , Gt 1  
1 T

T  1 t 2
 Gt  G  Gt 1  G 
var  Gt  
1 T
  Gt  G 
2
T  1 t 1

Page 34
9.3
Serial Correlation
9.3.1a
Computing
Autocorrelation
Making the substitutions, we get:
  G  G  G  G
T
t t 1
Eq. 9.13 r1  t 2
 G  G 
T
2
t
t 1

Page 35
9.3
Serial Correlation
9.3.1a
Computing
Autocorrelation
More generally, the k-th order sample

autocorrelation for a series y that gives the
correlation between observations that are k periods
apart is: T
Eq. 9.14
  yt  y  yt k  y 
rk  t  k 1 T
  yt  y 
2
t 1

Page 36
9.3
Serial Correlation
9.3.1a
Computing
Autocorrelation
Because (T - k) observations are used to compute

the numerator and T observations are used to
compute the denominator, an alternative that leads
to larger estimates in finite samples is:
1 T

T  k t  k 1
 yt  y  yt k  y 
Eq. 9.15 rk 
1 T
  yt  y 
2
T t 1

Page 37
9.3
Serial Correlation
9.3.1a
Computing
Autocorrelation
Applying this to our problem, we get for the first

four autocorrelations:
Eq. 9.16 r1  0.494 r2  0.411 r3  0.154 r4  0.200

Page 38
9.3
Serial Correlation
9.3.1a
Computing
Autocorrelation
How do we test whether an autocorrelation is

significantly different from zero?
– The null hypothesis is H0: ρk = 0
– A suitable test statistic is:
rk  0
Eq. 9.17 Z  T rk N  0,1
1T

Page 39
9.3
Serial Correlation
9.3.1a
Computing
Autocorrelation
For our problem, we have:
Z1  98  0.494  4.89, Z 2  98  0.414  4.10

Z3  98  0.154  1.52, Z 4  98  0.200  1.98
– We reject the hypotheses H0: ρ1 = 0 and
H0: ρ2 = 0
– We have insufficient evidence to reject
H0: ρ3 = 0
– ρ4 is on the borderline of being significant.
– We conclude that G, the quarterly growth rate
in U.S. GDP, exhibits significant serial
correlation at lags one and two
Page 40
9.3
Serial Correlation
9.3.1b
The Correlagram
The correlogram, also called the sample

autocorrelation function, is the sequence of
autocorrelations r1, r2, r3, …
– It shows the correlation between observations
that are one period apart, two periods apart,
three periods apart, and so on

Page 41
9.3
Serial Correlation FIGURE 9.6 Correlogram for G
9.3.1b
The Correlagram

Page 42
9.3
Serial Correlation
9.3.2
Serially Correlated
Errors
The correlogram can also be used to check

whether the multiple regression assumption
cov(et, es) = 0 for t ≠ s is violated

Page 43
9.3
Serial Correlation
9.3.2a
A Phillips Curve
Consider a model for a Phillips Curve:
Eq. 9.18 INFt  INFt E  γ U t  U t 1 
– If we initially assume that inflationary

expectations are constant over time (β1 = INFEt)
set β2= -γ, and add an error term:
Eq. 9.19 INFt  β1  β2 DUt  et

Page 44
9.3
Serial Correlation FIGURE 9.7 (a) Time series for Australian price inflation
9.3.2a
A Phillips Curve

Page 45
9.3 FIGURE 9.7 (b) Time series for the quarterly change in the Australian
Serial Correlation
unemployment rate
9.3.2a
A Phillips Curve

Page 46
9.3
Serial Correlation
9.3.2a
A Phillips Curve
To determine if the errors are serially correlated,

we compute the least squares residuals:
Eq. 9.20 eˆt  INFt  b1  b2 DUt 

Page 47
9.3 FIGURE 9.8 Correlogram for residuals from least-squares estimated
Serial Correlation
Phillips curve
9.3.2a
A Phillips Curve

Page 48
9.3
Serial Correlation
9.3.2a
A Phillips Curve The k-th order autocorrelation for the residuals can
be written as: T
 eˆ eˆ t t k
Eq. 9.21 rk  t  k 1
T
t
ˆ
e 2
t 1
– The least squares equation is:
INF  0.7776  0.5279 DU

Eq. 9.22
 se   0.0658  0.2294 

Page 49
9.3
Serial Correlation
9.3.2a
A Phillips Curve
The values at the first five lags are:
r1  0.549 r2  0.456 r3  0.433 r4  0.420 r5  0.339

Page 50
9.4
Other Tests for Serially Correlated
Errors

Page 51
9.4
Other Tests for
Serially Correlated
Errors
9.4.1
A Lagrange
Multiplier Test
An advantage of this test is that it readily

generalizes to a joint test of correlations at more
than one lag

Page 52
9.4
Other Tests for
Serially Correlated
Errors
9.4.1
A Lagrange
Multiplier Test
If et and et-1 are correlated, then one way to model

the relationship between them is to write:
Eq. 9.23 et  ρet 1  vt
– We can substitute this into a simple regression
equation:
Eq. 9.24 yt  β1  β2 xt  ρet 1  vt

Page 53
9.4
Other Tests for
Serially Correlated
Errors
9.4.1
A Lagrange
Multiplier Test
We have one complication: ê0 is unknown

– Two ways to handle this are:
1. Delete the first observation and use a total
of T observations
2. Set eˆ0  0 and use all T observations

Page 54
9.4
Other Tests for
Serially Correlated
Errors
9.4.1
A Lagrange
Multiplier Test
For the Phillips Curve:
 i  t  6.219 F  38.67 p-value  0.000

 ii  t  6.202 F  38.47 p-value  0.000
– The results are almost identical
– The null hypothesis H0: ρ = 0 is rejected at all
conventional significance levels
– We conclude that the errors are serially
correlated
Page 55
9.4
Other Tests for
Serially Correlated
Errors
9.4.1
A Lagrange
Multiplier Test
To derive the relevant auxiliary regression for the
autocorrelation LM test, we write the test equation
as:
Eq. 9.25 yt  β1  β2 xt  ρeˆt 1  vt
– But since we know that yt  b1  b2 xt  eˆt , we

get:
b1  b2 xt  eˆt  β1  β2 xt  ρeˆt 1  vt

Page 56
9.4
Other Tests for
Serially Correlated
Errors
9.4.1
A Lagrange
Multiplier Test
Rearranging, we get:
eˆt   β1  b1   β 2  b2  xt  ρeˆt 1  vt
Eq. 9.26
 γ1  γ 2 xt  ρeˆt 1  v
– If H0: ρ = 0 is true, then LM = T x R2 has an
approximate χ2(1) distribution
• T and R2 are the sample size and goodness-
of-fit statistic, respectively, from least
squares estimation of Eq. 9.26

Page 57
9.4
Other Tests for
Serially Correlated
Errors
9.4.1
A Lagrange
Multiplier Test
Considering the two alternative ways to handle ê0 :
 
iii LM   
T  1  R 2
 89  0.3102  27.61
 iv  LM  T  R 2  90  0.3066  27.59
– These values are much larger than 3.84, which
is the 5% critical value from a χ2(1)-distribution
• We reject the null hypothesis of no
autocorrelation
– Alternatively, we can reject H0 by examining
the p-value for LM = 27.61, which is 0.000

Page 58
9.4
Other Tests for
Serially Correlated
Errors
9.4.1a
Testing Correlation
at Longer Lags
For a four-period lag, we obtain:
 iii  LM  T  4   R 2  86  0.3882  33.4

 iv  LM  T  R 2  90  0.4075  36.7
– Because the 5% critical value from a χ2(4)-

distribution is 9.49, these LM values lead us to
conclude that the errors are serially correlated

Page 59
9.4
Other Tests for
Serially Correlated
Errors
9.4.2
The Durbin-
Watson Test
This is used less frequently today because its

critical values are not available in all software
packages, and one has to examine upper and lower
critical bounds instead
– Also, unlike the LM and correlogram tests, its
distribution no longer holds when the equation
contains a lagged dependent variable

Page 60
9.5
Estimation with Serially Correlated
Errors

Page 61
9.5
Estimation with
Serially Correlated
Errors
Three estimation procedures are considered:

1. Least squares estimation
2. An estimation procedure that is relevant when
the errors are assumed to follow what is
known as a first-order autoregressive model
et  ρet 1  vt
3. A general estimation strategy for estimating
models with serially correlated errors

Page 62
9.5
Estimation with
Serially Correlated
Errors
We will encounter models with a lagged

dependent variable, such as:
yt  δ  θ1 yt 1  δ0 xt  δ1 xt 1  vt

Page 63
9.5
Estimation with
Serially Correlated ASSUMPTION FOR MODELS WITH A LAGGED DEPENDENT VARIABLE
Errors
TSMR2A In the multiple regression model yt  β1  β2 xt 2   β K xK  vt

Where some of the xtk may be lagged values of y, vt is uncorrelated with all
xtk and their past values.

Page 64
9.5
Estimation with
Serially Correlated
Errors
9.5.1
Least Squares
Estimation
Suppose we proceed with least squares estimation
without recognizing the existence of serially
correlated errors. What are the consequences?
1. The least squares estimator is still a linear
unbiased estimator, but it is no longer best
2. The formulas for the standard errors usually
computed for the least squares estimator are
no longer correct
• Confidence intervals and hypothesis tests
that use these standard errors may be
misleading
Page 65
9.5
Estimation with
Serially Correlated
Errors
9.5.1
Least Squares
Estimation
It is possible to compute correct standard errors

for the least squares estimator:
– HAC (heteroskedasticity and autocorrelation
consistent) standard errors, or Newey-West
standard errors
• These are analogous to the heteroskedasticity
consistent standard errors

Page 66
9.5
Estimation with
Serially Correlated
Errors
9.5.1
Least Squares
Estimation
Consider the model yt = β1 + β2xt + et
– The variance of b2 is:
var  b2    wt2 var  et    wt ws cov  et , es 

t t s
Eq. 9.27   wt ws cov  et , es  

  wt2 var  et  1  ts 
t

  t
wt var  et 
2 

where
wt   xt  x   x  x
2
t t

Page 67
9.5
Estimation with
Serially Correlated
Errors
9.5.1
Least Squares
Estimation
When the errors are not correlated, cov(et, es) = 0,
and the term in square brackets is equal to one.
– The resulting expression
var  b2   t wt2 var  et 
is the one used to find heteroskedasticity-

consistent (HC) standard errors
– When the errors are correlated, the term in
square brackets is estimated to obtain HAC
standard errors

Page 68
9.5
Estimation with
Serially Correlated
Errors
9.5.1
Least Squares
Estimation
If we call the quantity in square brackets g and its

estimate ĝ , then the relationship between the two
estimated variances is:
Eq. 9.28 varHAC  b2   varHC  b2   gˆ

Page 69
9.5
Estimation with
Serially Correlated
Errors
9.5.1
Least Squares
Estimation
Let’s reconsider the Phillips Curve model:
INF  0.7776  0.5279 DU

Eq. 9.29  0.0658  0.2294   incorrect se 
 0.1030   0.3127   HAC se 

Page 70
9.5
Estimation with
Serially Correlated
Errors
9.5.1
Least Squares
Estimation
The t and p-values for testing H0: β2 = 0 are:

t  0.5279 0.2294  2.301 p  0.0238  from LS standard errors 
t  0.5279 0.3127  1.688 p  0.0950  from HAC standard errors 

Page 71
9.5
Estimation with
Serially Correlated
Errors
9.5.2
Estimating an
AR(1) Error Model
Return to the Lagrange multiplier test for serially

correlated errors where we used the equation:
Eq. 9.30 et  ρet 1  vt
– Assume the vt are uncorrelated random errors

with zero mean and constant variances:
Eq. 9.31 E  vt   0 var  vt    v2 cov  vt , vs   0 for t  s

Page 72
9.5
Estimation with
Serially Correlated
Errors
9.5.2
Estimating an
AR(1) Error Model
Eq. 9.30 describes a first-order autoregressive
model or a first-order autoregressive process for
et
– The term AR(1) model is used as an
abbreviation for first-order autoregressive
model
– It is called an autoregressive model because it
can be viewed as a regression model
– It is called first-order because the right-hand-
side variable is et lagged one period

Page 73
9.5
Estimation with
Serially Correlated
Errors
9.5.2a
Properties of an
AR(1) Error
We assume that:
Eq. 9.32 1  ρ  1
The mean and variance of et are:
 2
Eq. 9.33 E  et   0 var  et     2 v
1  ρ2
e
The covariance term is:

ρ k 2
Eq. 9.34 cov  et , et k   , k 0 v
1 ρ 2

Page 74
9.5
Estimation with
Serially Correlated
Errors
9.5.2a
Properties of an The correlation implied by the covariance is:
ρ k  corr  et , et  k 
AR(1) Error
cov  et , et  k 

var  et  var  et  k 
cov  et , et  k 

var  et 
Eq. 9.35

ρ k v2 1  ρ 2 
 v2 1  ρ 2 
 ρk
Page 75
9.5
Estimation with
Serially Correlated
Errors
9.5.2a
Properties of an Setting k = 1:
AR(1) Error
Eq. 9.36 ρ1  corr  et , et 1   ρ

– ρ represents the correlation between two errors that
are one period apart
• It is the first-order autocorrelation for e,
sometimes simply called the autocorrelation
coefficient
• It is the population autocorrelation at lag one for
a time series that can be described by an AR(1)
model
• r1 is an estimate for ρ when we assume a series
is AR(1)
Page 76
9.5
Estimation with
Serially Correlated
Errors
9.5.2a
Properties of an
AR(1) Error
Each et depends on all past values of the errors vt:
Eq. 9.37 et  vt  ρvt 1  ρ vt 2  ρ vt 3 

2 3
– For the Phillips Curve, we find for the first five

lags:
r1  0.549 r2  0.456 r3  0.433 r4  0.420 r5  0.339
– For an AR(1) model, we have:
ρˆ 1  ρˆ  r1  0.549

Page 77
9.5
Estimation with
Serially Correlated
Errors
9.5.2a
Properties of an
AR(1) Error
For longer lags, we have:
ρˆ 2  ρˆ   0.549   0.301
2 2
ρˆ 3  ρˆ 3   0.549   0.165
3
ρˆ 4  ρˆ   0.549   0.091
4 4
ρˆ 5  ρˆ 5   0.549   0.050
5

Page 78
9.5
Estimation with
Serially Correlated
Errors
9.5.2b
Nonlinear Least
Squares Estimation
Our model with an AR(1) error is:
Eq. 9.38 yt  β1  β2 xt  et with et  ρet 1  vt
with -1 < ρ < 1

– For the vt, we have:
Eq. 9.39 E  vt   0 var  vt    v2 cov  vt , vt 1   0 for t  s

Page 79
9.5
Estimation with
Serially Correlated
Errors
9.5.2b
Nonlinear Least
Squares Estimation
With the appropriate substitutions, we get:
Eq. 9.40 yt  β1  β2 xt  ρet 1  vt
– For the previous period, the error is:
Eq. 9.41 et 1  yt 1  β1  β2 xt 1
– Multiplying by ρ:
Eq. 9.42 ρet 1  et yt 1  ρβ1  ρβ2 xt 1

Page 80
9.5
Estimation with
Serially Correlated
Errors
9.5.2b
Nonlinear Least
Squares Estimation
Substituting, we get:
Eq. 9.43 yt  β1 1  ρ   β2 xt  ρyt 1  ρβ2 xt 1  vt

Page 81
9.5
Estimation with
Serially Correlated
Errors
9.5.2b
Nonlinear Least
Squares Estimation
The coefficient of xt-1 equals -ρβ2

– Although Eq. 9.43 is a linear function of the
variables xt , yt-1 and xt-1, it is not a linear
function of the parameters (β1, β2, ρ)
– The usual linear least squares formulas cannot
be obtained by using calculus to find the values
of (β1, β2, ρ) that minimize Sv
• These are nonlinear least squares estimates

Page 82
9.5
Estimation with
Serially Correlated
Errors
9.5.2b
Nonlinear Least
Squares Estimation
Our Phillips Curve model assuming AR(1) errors
is:
Eq. 9.44 INFt  β1 1  ρ   β2 DUt  ρINFt 1  ρβ2 DUt 1  vt
– Applying nonlinear least squares and presenting

the estimates in terms of the original
untransformed model, we have:
INF  0.7609  0.6944 DU et  0.557et 1  vt

Eq. 9.45
 se   0.1245  0.2479   0.090 
Page 83
9.5
Estimation with
Serially Correlated
Errors
9.5.2c
Generalized Least
Squares Estimation
Nonlinear least squares estimation of Eq. 9.43 is

equivalent to using an iterative generalized least
squares estimator called the Cochrane-Orcutt
procedure

Page 84
9.5
Estimation with
Serially Correlated
Errors
9.5.3
Estimating a More
General Model
We have the model:
Eq. 9.46 yt  β1 1  ρ   β2 xt  ρyt 1  ρβ2 xt 1  vt
– Suppose now that we consider the model:
Eq. 9.47 yt  δ  θ1 yt 1  δ0 xt  δ1 xt 1  vt
• This new notation will be convenient when

we discuss a general class of autoregressive
distributed lag (ARDL) models
–Eq. 9.47 is a member of this class
Page 85
9.5
Estimation with
Serially Correlated
Errors
9.5.3
Estimating a More
General Model
Note that Eq. 9.47 is the same as Eq. 9.47 since:

Eq. 9.48 δ  β1 1  ρ  δ0  β2 δ1  ρβ2 θ1  ρ
– Eq. 9.46 is a restricted version of Eq. 9.47 with

the restriction δ1 = -θ1δ0 imposed

Page 86
9.5
Estimation with
Serially Correlated
Errors
9.5.3
Estimating a More
General Model
Applying the least squares estimator to Eq. 9.47

using the data for the Phillips curve example
yields:
INF t  0.3336  0.5593INFt 1  0.6882 DU t  0.3200 DU t 1
Eq. 9.49
 se   0.0899   0.0908  0.2575  0.2499 

Page 87
9.5
Estimation with
Serially Correlated
Errors
9.5.3
Estimating a More
General Model
The equivalent AR(1) estimates are:

δˆ  βˆ 1 1  ρˆ   0.7609  1  0.5574   0.3368
θˆ 1  ρˆ  0.5574
δˆ  βˆ  0.6944
0 2
ˆ ˆ 2  0.5574   0.6944   0.3871

δˆ 1  ρβ
– These are similar to our other estimates

Page 88
9.5
Estimation with
Serially Correlated
Errors
9.5.3
Estimating a More
General Model
The original economic model for the Phillips

Curve was:
Eq. 9.50 INFt  INFt E  γ Ut  Ut 1 
– Re-estimation of the model after omitting DUt-1

yields:
INF t  0.3548  0.5282 INFt 1  0.4909 DU t

Eq. 9.51
 se   0.0876   0.0851  0.1921
Page 89
9.5
Estimation with
Serially Correlated
Errors
9.5.3
Estimating a More
General Model
In this model inflationary expectations are given

by:
INFt E  0.3548  0.5282INFt 1
– A 1% rise in the unemployment rate leads to an

approximate 0.5% fall in the inflation rate

Page 90
9.5
Estimation with
Serially Correlated
Errors
9.5.4
Summary of We have described three ways of overcoming the
Section 9.5 and
Looking Ahead effect of serially correlated errors:
1. Estimate the model using least squares with
HAC standard errors
2. Use nonlinear least squares to estimate the
model with a lagged x, a lagged y, and the
restriction implied by an AR(1) error
specification
3. Use least squares to estimate the model with a
lagged x and a lagged y, but without the
restriction implied by an AR(1) error
specification
Page 91
9.6
Autoregressive Distributed Lag
Models

Page 92
9.6
Autoregressive
Distributed Lag
Models
An autoregressive distributed lag (ARDL) model

is one that contains both lagged xt’s and lagged yt’s
Eq. 9.52 yt    0 xt  1xt 1   q xt q  1 yt 1    p yt  p  vt
– Two examples:
ADRL 1,1 : INFt  0.3336  0.5593INFt 1  0.6882 DU t  0.3200 DU t 1
ADRL 1, 0  : INFt  0.3548  0.5282 INFt 1  0.4909 DU t

Page 93
9.6
Autoregressive
Distributed Lag
Models
An ARDL model can be transformed into one with

only lagged x’s which go back into the infinite
past:
yt    0 xt  β1 xt 1  β 2 xt  2  β3 xt 3   et
Eq. 9.53 
    β s xt  s  et
s 0
– This model is called an infinite distributed

lag model

Page 94
9.6
Autoregressive
Distributed Lag
Models
Four possible criteria for choosing p and q:

1. Has serial correlation in the errors been
eliminated?
2. Are the signs and magnitudes of the estimates
consistent with our expectations from
economic theory?
3. Are the estimates significantly different from
zero, particularly those at the longest lags?
4. What values for p and q minimize information
criteria such as the AIC and SC?

Page 95
9.6
Autoregressive
Distributed Lag
Models
The Akaike information criterion (AIC) is:

 SSE  2 K
Eq. 9.54 AIC  ln  
 T  T
where K = p + q + 2
The Schwarz criterion (SC), also known as the
Bayes information criterion (BIC), is:
 SSE  K ln T 
Eq. 9.55 SC  ln  
 T  T
– Because Kln(T)/T > 2K/T for T ≥ 8, the SC
penalizes additional lags more heavily than
does the AIC
Page 96
9.6
Autoregressive
Distributed Lag
Models
9.6.1
The Phillips Curve
Consider the previously estimated ARDL(1,0)

model:
Eq. 9.56
INF t  0.3548  0.5282 INFt 1  0.4909 DU t , obs  90
 se   0.0876   0.0851  0.1921

Page 97
9.6
Autoregressive
Distributed Lag FIGURE 9.9 Correlogram for residuals from Phillips curve ARDL(1,0) model
Models
9.6.1
The Phillips Curve

Page 98
9.6
Autoregressive
Distributed Lag Table 9.3 p-values for LM Test for Autocorrelation
Models
9.6.1
The Phillips Curve

Page 99
9.6
Autoregressive
Distributed Lag
Models
9.6.1
The Phillips Curve
For an ARDL(4,0) version of the model:
INF t  0.1001  0.2354 INFt 1  0.1213INFt  2  0.1677 INFt 3
Eq. 9.57
 se   0.0983  0.1016   0.1038  0.1050 
 0.2819INFt -4  0.7902DU t
 0.1014  0.1885 obs  87

Page 100
9.6
Autoregressive
Distributed Lag
Models
9.6.1
The Phillips Curve
Inflationary expectations are given by:
INFt E  0.1001  0.2354INFt 1  0.1213INFt 2  0.1677 INFt 3  0.2819INFt -4

Page 101
9.6
Autoregressive
Distributed Lag Table 9.4 AIC and SC Values for Phillips Curve ARDL Models
Models
9.6.1
The Phillips Curve

Page 102
9.6
Autoregressive
Distributed Lag
Models
9.6.2
Okun’s Law
Recall the model for Okun’s Law:
DU t  0.5836  0.2020Gt  0.1653Gt 1  0.0700G t 2 , obs  96

Eq. 9.58
 se   0.0472   0.0324  0.0335  0.0331

Page 103
9.6
Autoregressive
Distributed Lag FIGURE 9.10 Correlogram for residuals from Okun’s law ARDL(0,2) model
Models
9.6.2
Okun’s Law

Page 104
9.6
Autoregressive
Distributed Lag Table 9.5 AIC and SC Values for Okun’s Law ARDL Models
Models
9.6.2
Okun’s Law

Page 105
9.6
Autoregressive
Distributed Lag
Models
9.6.2
Okun’s Law
Now consider this version:
DU t  0.3780  0.3501DU t 1  0.1841Gt  0.0992G t 1 , obs  96

Eq. 9.59
 se   0.0578 0.0846   0.0307   0.0368

Page 106
9.6
Autoregressive
Distributed Lag
Models
9.6.3
Autoregressive
Models
An autoregressive model of order p, denoted

AR(p), is given by:
Eq. 9.60 yt  δ  θ1 yt 1  θ2 yt 2   θ p yt  p  vt

Page 107
9.6
Autoregressive
Distributed Lag
Models
9.6.3
Autoregressive
Models
Consider a model for growth in real GDP:
G t  0.4657  0.3770Gt 1  0.2462Gt 2

Eq. 9.61
 se  0.1433  0.1000   0.1029  obs = 96

Page 108
9.6
Autoregressive
Distributed Lag FIGURE 9.11 Correlogram for residuals from AR(2) model for GDP growth
Models
9.6.3
Autoregressive
Models

Page 109
9.6
Autoregressive
Distributed Lag Table 9.6 AIC and SC Values for AR Model of Growth in U.S. GDP
Models
9.6.3
Autoregressive
Models

Page 110
9.7
Forecasting

Page 111
9.7
Forecasting
We consider forecasting using three different

models:
1. AR model
2. ARDL model
3. Exponential smoothing model

Page 112
9.7
Forecasting
9.7.1
Forecasting with
an AR Model
Consider an AR(2) model for real GDP growth:
Eq. 9.62 Gt  δ  θ1Gt 1  θ2Gt 2  vt
The model to forecast GT+1 is:
GT 1  δ  θ1GT  θ2GT 1  vT 1

Page 113
9.7
Forecasting
9.7.1
Forecasting with
an AR Model
The growth values for the two most recent

quarters are:
GT = G2009Q3 = 0.8
GT-1 = G2009Q2 = -0.2
The forecast for G2009Q4 is:
GˆT 1  δˆ  θˆ 1GT  θˆ 2GT 1
Eq. 9.63  0.46573  0.37700  0.8  0.24624   0.2 
 0.7181

Page 114
9.7
Forecasting
9.7.1
Forecasting with
an AR Model
For two quarters ahead, the forecast for G2010Q1 is:
GˆT  2  δˆ  θˆ 1GT 1  θˆ 2GT

Eq. 9.64  0.46573  0.37700  0.71808  0.24624  0.8
 0.9334
For three periods out, it is:
GˆT 3  δˆ  θˆ 1GT  2  θˆ 2GT 1

Eq. 9.65  0.46573  0.37700  0.93343  0.24624  0.71808
 0.9945

Page 115
9.7
Forecasting
9.7.1
Forecasting with
an AR Model
Summarizing our forecasts:

– Real GDP growth rates for 2009Q4, 2010Q1,
and 2010Q2 are approximately 0.72%, 0.93%,
and 0.99%, respectively

Page 116
9.7
Forecasting
9.7.1
Forecasting with
an AR Model
A 95% interval forecast for j periods into the

future is given by:
GˆT  j  t 0.975,df  σ̂ j
where σ̂ j is the standard error of the forecast
error and df is the number of degrees of freedom
in the estimation of the AR model

Page 117
9.7
Forecasting
9.7.1
Forecasting with
an AR Model
The first forecast error, occurring at time T+1, is:
    
u1  GT 1  GˆT 1  δ  δˆ  θ1  θˆ1 GT  θ2  θˆ 2 GT 1  vT 1 
Ignoring the error from estimating the coefficients,
we get:
Eq. 9.66 u1  vT 1

Page 118
9.7
Forecasting
9.7.1
Forecasting with
an AR Model
The forecast error for two periods ahead is:
Eq. 9.67  
u2  θ1 GT 1  GˆT 1  vT  2  θ1u1  vT  2  θ1vT 1  vT 2
The forecast error for three periods ahead is:
Eq. 9.68 
u3  θ1u2  θ2u1  vT 3  θ12  θ2 vT 1  θ1vT 2  vT 3 

Page 119
9.7
Forecasting
9.7.1
Forecasting with
an AR Model
Because the vt’s are uncorrelated with constant

variance  v2, we can show that:
σ12  var  u1   σ v2
σ 22  var  u2   σ v2 1  θ12  
σ  var  u3   σ
2
3
2
v  θ  θ2
2
1 
2

 θ12  1

Page 120
9.7
Forecasting Table 9.7 Forecasts and Forecast Intervals for GDP Growth
9.7.1
Forecasting with
an AR Model

Page 121
9.7
Forecasting
9.7.2
Forecasting with
an ARDL Model
Consider forecasting future unemployment using

the Okun’s Law ARDL(1,1):
Eq. 9.69 DUt  δ  θ1DUt 1  δ0Gt  δ1Gt 1  vt
The value of DU in the first post-sample quarter

is:
Eq. 9.70 DUT 1  δ  θ1DUT  δ0GT 1  δ1GT  vT 1
– But we need a value for GT+1

Page 122
9.7
Forecasting
9.7.2
Forecasting with
an ARDL Model
Now consider the change in unemployment

– Rewrite Eq. 9.70 as:
UT 1  UT  δ  θ1 UT  UT 1   δ0GT 1  δ1GT  vT 1
– Rearranging:
UT 1  δ   θ1  1UT  θ1UT 1  δ0GT 1  δ1GT  vT 1

Eq. 9.71
 δ  θ1*UT  θ*2UT 1  δ0GT 1  δ1GT  vT 1

Page 123
9.7
Forecasting
9.7.2
Forecasting with
an ARDL Model
For the purpose of computing point and interval

forecasts, the ARDL(1,1) model for a change in
unemployment can be written as an ARDL(2,1)
model for the level of unemployment
– This result holds not only for ARDL models
where a dependent variable is measured in
terms of a change or difference, but also for
pure AR models involving such variables

Page 124
9.7
Forecasting
9.7.3
Exponential
Smoothing
Another popular model used for predicting the

future value of a variable on the basis of its history
is the exponential smoothing method
– Like forecasting with an AR model, forecasting
using exponential smoothing does not utilize
information from any other variable

Page 125
9.7
Forecasting
9.7.3
Exponential
Smoothing
One possible forecasting method is to use the

average of past information, such as:
yT  yT 1  yT 2
yˆT 1 
3
– This forecasting rule is an example of a simple
(equally-weighted) moving average model with
k=3

Page 126
9.7
Forecasting
9.7.3
Exponential
Smoothing
Now consider a form in which the weights decline

exponentially as the observations get older:
yˆT 1  αyT  α 1  α  yT 1  α 1  α  yT 2 
1 2
Eq. 9.72
– We assume that 0 < α < 1

– Also, it can be shown that:
 α 1  α   1
 s
s 0

Page 127
9.7
Forecasting
9.7.3
Exponential
Smoothing
For forecasting, recognize that:
1  α  yˆT  α 1  α  yT 1  α 1  α  yT 2  α 1  α  yT 3 
2 3
Eq. 9.73
– We can simplify to:
Eq. 9.74 yˆT 1  αyT  1  α  yˆT

Page 128
9.7
Forecasting
9.7.3
Exponential
Smoothing
The value of α can reflect one’s judgment about
the relative weight of current information
– It can be estimated from historical information
by obtaining within-sample forecasts:
Eq. 9.75 yˆt  αyt 1  1  α  yˆt 1 t  2,3, , T
• Choosing α that minimizes the sum of

squares of the one-step forecast errors:
Eq. 9.76 vt  yt  yˆt  yt   αyt 1 + 1  α  yˆt 1 

Page 129
9.7 FIGURE 9.12 (a) Exponentially smoothed forecasts for GDP growth with α
Forecasting
= 0.38
9.7.3
Exponential
Smoothing

Page 130
9.7 FIGURE 9.12 (b) Exponentially smoothed forecasts for GDP growth with α
Forecasting
= 0.8
9.7.3
Exponential
Smoothing

Page 131
9.7
Forecasting
9.7.3
Exponential
Smoothing
The forecasts for 2009Q4 from each value of α

are:
α  0.38 : GˆT 1  αGT  1  α  GˆT  0.38  0.8  1  0.38    0.403921
= 0.0536
α  0.8 : GˆT 1  αGT  1  α  GˆT  0.8  0.8  1  0.8    0.393578 
= 0.5613

Page 132
9.8
Multiplier Analysis

Page 133
9.8
Multiplier Analysis
Multiplier analysis refers to the effect, and the

timing of the effect, of a change in one variable on
the outcome of another variable

Page 134
9.8
Multiplier Analysis
Let’s find multipliers for an ARDL model of the

form:
Eq. 9.77 yt    1 yt 1    p yt  p  0 xt  1 xt 1   q xt q  vt
– We can transform this into an infinite

distributed lag model:
Eq. 9.78 yt  α  β0 x t + β1 xt 1  β2 xt 2  β3 xt 3   et

Page 135
9.8
Multiplier Analysis
The multipliers are defined as:

yt
βs   s period delay multiplier
xt  s
β
j 0
j  s period interim multiplier
β
j 0
j  total multiplier

Page 136
9.8
Multiplier Analysis
The lag operator is defined as:

Lyt  yt 1
– Lagging twice, we have:
L  Lyt   Lyt 1  yt 2
– Or:
L2 yt  yt 2
– More generally, we have:
Ls yt  yt  s

Page 137
9.8
Multiplier Analysis
Now rewrite our model as:
yt    1 Lyt  2 L2 yt    p Lp yt  0 xt  1 Lxt  2 L2 xt
Eq. 9.79
  q Lq xt  vt

Page 138
9.8
Multiplier Analysis
Rearranging terms:
Eq. 9.80  1 2 
1   L   L2
  p Lp  yt     0  1L  2 L2   q Lq  xt  vt

Page 139
9.8
Multiplier Analysis
Let’s apply this to our Okun’s Law model

– The model:
Eq. 9.81 DUt  δ  θ1DUt 1  δ0Gt  δ1Gt 1  vt
can be rewritten as:
Eq. 9.82 1  θ1L  DUt  δ   δ0  δ1L  Gt  vt

Page 140
9.8
Multiplier Analysis
Define the inverse of (1 – θ1L) as (1 – θ1L)-1 such

that:
1  θ1L  1  θ1L   1
1

Page 141
9.8
Multiplier Analysis
Multiply both sides of Eq. 9.82 by (1 – θ1L)-1:
DUt  1  θ1L  δ  1  θ1L   δ0  δ1L  Gt  1  θ1L 

1 1 1
Eq. 9.83 vt
– Equating this with the infinite distributed lag

representation:
DU t  α  β0Gt  β1Gt 1  β 2Gt 2  β3Gt 3   et

 G  e
Eq. 9.84
 α  β0  β1 L  β 2 L2  β3 L3  t t

Page 142
9.8
Multiplier Analysis
For Eqs. 9.83 and 9.84 to be identical, it must be

true that:
α= 1  θ1 L  δ
1
Eq. 9.85
 1  θ1 L   δ0  δ1L 
1
Eq. 9.86 β0  β1 L  β 2 L  β3 L 
2 3
et  1  θ1 L  vt
1
Eq. 9.87

Page 143
9.8
Multiplier Analysis
Multiply both sides of Eq. 9.85 by (1 – θ1L) to

obtain (1 – θ1L)α = δ.
– Note that the lag of a constant that does not
change so Lα = α
– Now we have:
δ
1  θ1  α  δ and α 
1  θ1

Page 144
9.8
Multiplier Analysis
Multiply both sides of Eq. 9.86 by (1 – θ1L):

δ0  δ1 L  1  θ1L  β 0  β1 L  β 2 L2  β3 L3  
 β0  β1 L  β 2 L2  β3 L3 
Eq. 9.88
 β0θ1 L  β1θ1 L2  β 2θ1 L3 
 β0   β1  β0θ1  L  β 2  β1θ1  L2  β3  β 2θ1  L3 

Page 145
9.8
Multiplier Analysis
Rewrite Eq. 9.86 as:

Eq. 9.89 δ0  δ1L  0L2  0L3  β0  β1  β0θ1  L  β2  β1θ1  L2  β3  β2θ1  L3 
– Equating coefficients of like powers in L yields:

δ0 = β 0
δ1  β1  β 0θ1
0  β 2  β1θ1
0  β3  β 2θ1
and so on
Page 146
9.8
Multiplier Analysis
We can now find the β’s using the recursive

equations:
β 0 = δ0
Eq. 9.90 β1  δ1  β 0θ1
β j  β j 1θ1 for j  2

Page 147
9.8
Multiplier Analysis
You can start from the equivalent of Eq. 9.88

which, in its general form, is:
δ0  δ1L  δ2 L2  
 δq Lq  1  θ1L  θ 2 L2   θ p Lp 
 
Eq. 9.91
 β0  β1L  β 2 L2  β3 L3 
– Given the values p and q for your ARDL

model, you need to multiply out the above
expression, and then equate coefficients of like
powers in the lag operator

Page 148
9.8
Multiplier Analysis
For the Okun’s Law model:
DU t  0.3780  0.3501DUt 1  0.1841Gt  0.0992Gt 1
– The impact and delay multipliers for the first

four quarters are:
βˆ 0 = δˆ 0  0.1841
βˆ  δˆ  βˆ θˆ  0.099155  0.184084  0.350116  0.1636
1 1 0 1
βˆ 2  βˆ 1θˆ 1  0.163606  0.350166  0.0573

βˆ  βˆ θˆ  0.057281 0.350166  0.0201
3 2 1
βˆ 4  βˆ 3θˆ 1  0.020055  0.350166  0.0070

Page 149
9.8
Multiplier Analysis FIGURE 9.13 Delay multipliers from Okun’s law ARDL(1,1) model

Page 150
9.8
Multiplier Analysis
We can estimate the total multiplier given by:


β
j 0
j
and the normal growth rate that is needed to

maintain a constant rate of unemployment:

GN  α β
j 0
j

Page 151
9.8
Multiplier Analysis
We can show that:

 ˆ  δˆ θˆ
δ 0.163606

j 0
ˆ
β j  δ0  1
ˆ
0 1
1  θ1
 0.184084 
1  0.350116
 0.4358
– An estimate for α is given by:

δ̂ 0.37801
α̂    0.5817
1  θˆ 1 0.649884
– Therefore, normal growth rate is:
0.5817
Ĝ N   1.3% per quarter
0.4358

Page 152
Key Words

Page 153
Keywords
AIC criterion dynamic models LM test

AR(1) error exponential multiplier analysis
AR(p) model smoothing nonlinear least
ARDL(p,q) model finite distributed lag squares
autocorrelation forecast error out-of-sample
Autoregressive forecast intervals forecasts
distributed lags forecasting sample
autoregressive HAC standard errors autocorrelations
error impact multiplier serial correlation
autoregressive standard error of
infinite distributed forecast error
model lag
BIC criterion SC criterion
interim multiplier
correlogram total multiplier
lag length
delay multiplier T x R2 form of LM
lag operator test
distributed lag lagged dependent
weight within-sample
variable forecasts
Page 154
Appendices

Page 155
9A
The Durbin-
Watson Test
For the Durbin-Watson test, the hypotheses are:

H0 :   0 H1 :   0
The test statistic is:
T
  eˆt  eˆt 1 
2
Eq. 9A.1 d t 2
T
t
ˆ
e 2
t 1

Page 156
9A
The Durbin-
Watson Test
We can expand the test statistic as:

T T T
 t  t 1  2 eˆt eˆt 1
ˆ
e 2
 ˆ
e 2
d t 2 t 2
T
t 2
t
ˆ
e 2
t 1
T T T
 eˆ  eˆ  eˆt eˆt 1
Eq. 9A.2 2 2
t t 1
 t 2
T
 t 2
T
2 t 2
T
t
ˆ
e 2
t
ˆ
e 2
t
ˆ
e 2
t 1 t 1 t 1
 1  1  2r1
Page 157
9A
The Durbin-
Watson Test
We can now write:
Eq. 9A.3 d  2 1  r1 
– If the estimated value of ρ is r1 = 0, then the
Durbin-Watson statistic d ≈ 2
• This is taken as an indication that the model
errors are not autocorrelated
– If the estimate of ρ happened to be r1 = 1 then
d≈0
• A low value for the Durbin-Watson statistic
implies that the model errors are correlated,
and ρ > 0
Page 158
9A
The Durbin-
Watson Test FIGURE 9A.1 Testing for positive autocorrelation

Page 159
9A
The Durbin- FIGURE 9A.2 Upper and lower critical value bounds for the Durbin-
Watson Test
Watson test
9A.1
The Durbin-
Watson Bounds
Test

Page 160
9A
The Durbin-
Watson Test
9A.1
The Durbin-
Watson Bounds
Test
Decision rules, known collectively as the Durbin-

Watson bounds test:
– If d < dLc: reject H0: ρ = 0 and accept
H1: ρ > 0
– If d > dUc do not reject H0: ρ = 0
– If dLc < d < dUc, the test is inconclusive

Page 161
9B
Properties of the
AR(1) Error
Note that:
et  ρet 1  vt
 ρ  ρet  2  vt 1   vt
Eq. 9B.1
 ρ 2 et  2  ρvt 1  vt
Further substitution shows that:
et  ρ  ρet 3  vt  2   ρvt 1  vt
2
Eq. 9B.2
 ρ3et 3  ρ 2 vt  2  ρvt 1  vt

Page 162
9B
Properties of the
AR(1) Error
Repeating the substitution k times and rearranging:

k 1
Eq. 9B.3 et  ρ et k  vt  ρvt 1  ρ vt 2 
k 2
 ρ vt k 1
If we let k → ∞, then we have:
Eq. 9B.4 et  vt  ρvt 1  ρ2vt 2  ρ3vt 3 

Page 163
9B
Properties of the
AR(1) Error
We can now find the properties of et:

E  et   E  vt   ρE  vt 1   ρ 2 E  vt  2   ρ3 E  vt 3  
 0  ρ  0  ρ 2  0  ρ3  0 
0
var  et   var  vt   ρ 2 var  vt 1   ρ 4 var  vt  2   ρ6 var  vt 3  
 v2  ρ2 v2  ρ4 v2  ρ6 v2 
 v2 1  ρ2  ρ4  ρ6  
v2

1  ρ2
Page 164
9B
Properties of the
AR(1) Error
The covariance for one period apart is:

cov  et , et 1   E  et et t 
 E  vt  ρvt 1  ρ vt  2  ρ vt 3 
 2 3

 v  ρv  ρ v  ρ v  
t 1 t 2
2
t 3
3
t 4
 ρE  v   ρ E  v   ρ E  v  
2
t 1
3 2
t 2
5 2
t 3
 ρ 1  ρ  ρ  
2
v
2 4
ρv2

1  ρ2
Page 165
9B
Properties of the
AR(1) Error
Similarly, the covariance for k periods apart is:
ρ k v2
cov  et , et  k   k 0
1  ρ2

Page 166
9C
Generalized Least
Squares Estimation
We are considering the simple regression model

with AR(1) errors:
yt  1  2 xt  et et  et 1  vt
To specify the transformed model we begin with:
Eq. 9C.1 yt  1  2 xt  yt 1  1  2 xt 1  vt
– Rearranging terms:
Eq. 9C.2 yt  yt 1  1 1     2  xt  xt 1   vt

Page 167
9C
Generalized Least
Squares Estimation
Defining the following transformed variables:
yt  yt  yt 1 xt2  xt  xt 1 xt1  1  
Substituting the transformed variables, we get:
Eq. 9C.3 yt  xt11  xt22  vt

Page 168
9C
Generalized Least
Squares Estimation
There are two problems:

1. Because lagged values of yt and xt had to be
formed, only (T - 1) new observations were
created by the transformation
2. The value of the autoregressive parameter ρ is
not known

Page 169
9C
Generalized Least
Squares Estimation
For the second problem, we can write Eq. 9C.1 as:
Eq. 9C.4 yt 1 2 xt  ( yt 1 1 2 xt 1 )  vt
For the first problem, note that:

y1  1  x12  e1
and that
1  2 y1  1  2 1  1  2 x12  1  2 e1

Page 170
9C
Generalized Least
Squares Estimation
Or:
Eq. 9C.5 y1  x11

 
1  x122  e1
where
y1  1  2 y1 x11  1  2
Eq. 9C.6
x12  1  2 x1 e1  1  2 e1

Page 171
9C
Generalized Least
Squares Estimation
To confirm that the variance of e*1 is the same as

that of the errors (v2, v3,…, vT), note that:
 2
var(e1 )  (1  2 ) var(e1 )  (1  2 ) v 2  v2
1 

Page 172

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Chapter 9

Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

When modeling relationships between variables,

Chapter 9: Regression with Time Series Data:

There is also the possible existence of dynamic

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

• Because of the existence of these lagged

Chapter 9: Regression with Time Series Data:

Eq. 9.4 yt  f ( xt )  et et  f (et 1 )

• In this case et is correlated with et - 1

Chapter 9: Regression with Time Series Data:

cov  yi , y j   cov  ei , e j   0 for i  j

• For time series, this is written as:

cov  yt , ys   cov  et , es   0 for t  s

– The dynamic models in Eqs. 9.2, 9.3 and 9.4

Chapter 9: Regression with Time Series Data:

A stationary variable is one that is not explosive,

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

Consider a linear model in which, after q time

– Note the notation change: βs is used to denote

Chapter 9: Regression with Time Series Data:

Model 9.5 has two uses:

Chapter 9: Regression with Time Series Data:

Assume xt is increased by one unit and then

Chapter 9: Regression with Time Series Data:

The effect of a one-unit change in xt is distributed

Chapter 9: Regression with Time Series Data:

– In this model the change in the unemployment

We can expand this to include lags:

Eq. 9.10 DUt    β0Gt  β1Gt 1  β2Gt 2   βqGt q  et

We can calculate the growth in output, G, as:

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

When is assumption TSMR5, cov(et, es) = 0 for

Chapter 9: Regression with Time Series Data:

Chapter 9: Regression with Time Series Data:

Recall that the population correlation between two

Chapter 9: Regression with Time Series Data:

The notation ρ1 is used to denote the population

The first-order sample autocorrelation for G is

Chapter 9: Regression with Time Series Data:

Making the substitutions, we get:

Chapter 9: Regression with Time Series Data:

More generally, the k-th order sample

Chapter 9: Regression with Time Series Data: