1 CHAPTER TWENTY-ONE: CONCEPTS 831 TIME SERIES ECONOMETRICS: SOME BASIC

21.2 Key Concepts: Page 796 1. Stochastic process 2. Stationarity process 3. Purely random process 4. Nonstationarity process 5. Integrated variables 6. Random walk models 7. Coinegrattion 8. Deterministic and stochastic trends . 21.3. What is the meaning of a unit root? 21.4. If a time series is I(3), how many times would you have to difference itto make it stationary? 21.5. What are DickeyFuller (DF) and augmented DF tests? 21.6. What are EngleGranger (EG) and augmented EG tests? 21.7. What is the meaning of cointegration? 21.8. What is the difference, if any, between tests of unit roots and tests ofcointegration? 21.9. What is spurious regression? 21.10. What is the connection between cointegration and spurious regression? 21.11. What is the difference between a deterministic trend and a stochastictrend? 21.12. What is meant by a trend-stationary process (TSP) and a differencestationary process (DSP)? 21.13. What is a random walk (model)? 21.14. For a random walk stochastic process, the variance is innite. Do youagree? Why? 21.15. What is the error correction mechanism (ECM)? What is its relationwith cointegration?

2 Problems. 21.16. Using the data given in Table 21.1, obtain sample correlograms up to25 lags for the time series PCE, PDI, Prots, and Dividends. What gen-eral pattern do you see? Intuitively, which one(s) of these time seriesseem to be stationary? 21.17. For each of the time series of exercise 21.16, use the DF test to nd outif these series contain a unit root. If a unit root exists, how would youcharacterize such a time series? 21.18. Continue with exercise 21.17. How would you decide if the ADF test ismore appropriate than the DF test? 21.19. Consider the dividends and prots time series given in Table 21.1. Sincedividends depend on prots, consider the following simple model:Dividendst = 1 + 2Prots + ut a. Would you expect this regression to suffer from the spurious regres-sion phenomenon? Why? b. Are Dividends and Prots time series cointegrated? How do you testfor this explicitly? If, after testing, you nd that they are cointegrated,would your answer in a change? c. Employ the error correction mechanism (ECM) to study the short-and long-run behavior of dividends in relation to prots. d. If you examine the Dividends and Prots series individually, do they exhibit stochastic or deterministic trends? What tests do you use? *e. Assume Dividends and Prots are cointegrated. Then, instead of re-gressing dividends on prots, you regress prots on dividends. Is such a regression valid?

Stationary Stochastic Processes A type of stochastic process that has received a great deal of attention and scrutiny by time series analysts is the so-called stationary stochastic process. Broadly speaking, a stochastic process is said to be stationary if its mean and variance are constant over time and the value of the covariance between the two time periods depends only on the distance or gap or lag between the two time periods and not the actual time at which the covariance is com-puted. In the time series literature, such a stochastic process is known as a weakly stationary, or covariance stationary, or second-order stationary, or wide sense, stochastic process. For the purpose of this chapter, and in most practical situations, this type of stationarity often sufces.6 To explain weak stationarity, let Yt be a stochastic time series with these properties: Mean: E(Yt ) = (21.3.1)

3 Variance: var (Yt ) = E(Yt )2 = 2 (21.3.2) Covariance: k = E[(Yt )(Yt+k )] (21.3.3) wherek, the covariance (or autocovariance) at lag k, is the covariance between the values of Yt and Yt+k, that is, between two Y values k periods apart. If k = 0, we obtain 0, which is simply the variance of Y ( = 2); if k = 1, 1 is the covariance between two adjacent values of Y, the type of covariance we encountered in Chapter 12 (recall the Markov rst-order autoregressive scheme). Suppose we shift the origin of Y from Yt to Yt+m (say, from the rst quar-ter of 1970 to the rst quarter of 1975 for our GDP data). Now if Yt is to be stationary, the mean, variance, and autocovariancesof Yt+m must be the same as of Yt.

Nonstationary Stochastic Processes Although our interest is in stationary time series, one often encounters nonstationary time series, the classic example being the random walk model (RWM). It is often said that asset prices, such as stock prices or exchange rates, follow a random walk; that is, they are nonstationary. We distinguish two types of random walks: (1) random walk without drift (i.e., no constant or intercept term) and (2) random walk with drift (i.e., a constant term is present)

Random Walk without Drift. Suppose ut is a white noise error term with mean 0 and variance 2. Then the series Yt is said to be a random walk if Yt = Yt1 + ut (21.3.4) In the random walk model, as (21.3.4) shows, the value of Y at time t is equal to its value at time (t 1) plus a random shock; thus it is an AR(1) model in the language of Chapters 12 and 17. We can think of (21.3.4) as a regression of Y at time t on its value lagged one period. Believers in the efcient capital market hypothesis argue that stock prices are essentially random and therefore there is no scope for protable speculation in the stock market: If one could predict tomorrows price on the basis of todays price, we would all be millionaires. Now from (21.3.4) we can write Y1 = Y0 + u1 Y2 = Y1 + u2 = Y0 + u1 + u2 Y3 = Y2 + u3 = Y0 + u1 + u2 + u3 In general, if the process started at some time 0 with a value of Y0, we have Yt = Y0 +

(21.3.5)

4 Therefore, E(Yt ) = E(Y0 +

) = Y0

In like fashion, it can be shown that var (Yt ) = t 2 (21.3.7) As the preceding expression shows, the mean of Y is equal to its initial, or starting, value, which is constant, but as t increases, its variance increases indenitely, thus violating a condition of stationarity. In short, the RWM without drift is a nonstationary stochastic process. In practice Y0 is often set at zero, in which case E(Yt ) = 0. An interesting feature of RWM is the persistence of random shocks (i.e., random errors), which is clear from (21.3.5): Yt is the sum of initial Y0 plus the sum of random shocks. As a result, the impact of a particular shock does not die away. For example, if u2 = 2 rather than u2 = 0, then all Yt s from Y2 onward will be 2 units higher and the effect of this shock never dies out. That is why random walk is said to have an innite memory. As Kerry Patterson notes, random walk remembers the shock forever10; that is, it hasinnite memory.

Random Walk with Drift. Let us modify (21.3.4) as follows: Yt = + Yt1 + ut (21.3.9) where is known as the drift parameter. The name drift comes from the fact that if we write the preceding equation as Yt Yt1 = Yt = + ut (21.3.10) it shows that Yt drifts upward or downward, depending on being positive negative. Note that model (21.3.9) is also an AR(1) model. or

Following the procedure discussed for random walk without drift, it can be shown that for the random walk with drift model (21.3.9), E(Yt ) = Y0 + t (21.3.11) var (Yt ) = t 2 (21.3.12) As you can see, for RWM with drift the mean as well as the variance increases over time, again violating the conditions of (weak) stationarity. In short, RWM, with or without drift, is a nonstationary stochastic process. To give a glimpse of the random walk with and without drift, we conducted two simulations as follows: Yt = Y0 + ut (21.3.13)

5 whereut are white noise error terms such that each ut N(0, 1); that is, each ut follows the standard normal distribution. From a random number generator, we obtained 500 values of u and generated Yt as shown in (21.3.13). We assumed Y0 = 0. Thus, (21.3.13) is an RWM without drift. Now consider Yt = + Y0 + ut (21.3.14) 21.4 UNIT ROOT STOCHASTIC PROCESS Let us write the RWM (21.3.4) as: Yt = Yt1 + ut 1 1 (21.4.1) This model resembles the Markov rst-order autoregressive model that we discussed in the chapter on autocorrelation. If = 1, (21.4.1) becomes a RWM (without drift). If is in fact 1, we face what is known as the unit root problem, that is, a situation of nonstationarity; we already know that in this case the variance of Yt is not stationary. The name unit root is due to the fact that = 1.11 Thus the terms nonstationarity, random walk, and unit root can be treated as synonymous. If, however, || 1, that is if the absolute value of is less than one, then it can be shown that the time series Yt is stationary in the sense we have dened it. In practice, then, it is important to nd out if a time series possesses a unit root.

21.5 TREND STATIONARY STOCHASTIC PROCESSES

(TS)

AND

DIFFERENCE

STATIONARY

(DS)

The distinction between stationary and nonstationary stochastic processes (or time series) has a crucial bearing on whether the trend (the slow long-run evolution of the time series under consideration) observed in the con-structed time series in Figures 21.3 and 21.4 or in the actual economic time series of Figures 21.1 and 21.2 is deterministic or stochastic. Broadly speaking, if the trend in a time series is completely predictable and not variable, we call it a deterministic trend, whereas if it is not predictable, we call it a stochastic trend. To make the denition more formal, consider the fol-lowing model of the time series Yt . Yt = 1 + 2t + 3Yt1 + ut (21.5.1) Now we have the following possibilities: Pure random walk: If in (21.5.1) 1 = 0, 2 = 0, 3 = 1, we get Yt = Yt1 + ut (21.5.2) which is nothing but a RWM without drift and is therefore nonstationary. But note that, if we write (21.5.2) as
Yt =(Yt Yt1) = ut (21.3.8)

6 it becomes stationary, as noted before. Hence, a RWM without drift is a difference stationary process (DSP).

Random walk with drift: If in (21.5.1) 1 0 , 2 = 0, 3 = 1, we get Yt = 1 + Yt1 + ut (21.5.3) which is a random walk with drift and is therefore nonstationary. If we write it as
Yt = 1 + ut (21.5.3a) (Yt Yt1) =

this means Yt will exhibit a positive (1 > 0) or negative (1 < 0) trend (see Figure 21.4). Such a trend is called a stochastic trend. Equation (21.5.3a)is a DSP process because the nonstationarity in Yt can be eliminated by tak-ing rst differences of the time series.

Deterministic trend: If in (21.5.1), 1 0 , 2 0 , 3 = 0, we obtain Yt = 1 + 2t + ut (21.5.4) which is called a trend stationary process (TSP). Although the mean of Ytis 1 + 2t, which is not constant, its variance ( = 2) is. Once the values of1 and 2 are known, the mean can be forecast perfectly. Therefore, if wesubtract the mean of Yt from Yt , the resulting series will be stationary, hence the name trend stationary. This procedure of removing the (deterministic)trend is called detrending.

Random walk with drift and deterministic trend: If in (21.5.1), 1 0 ,2 0 , 3 = 1, we obtain: Yt = 1 + 2t + Yt1 + ut (21.5.5) we have a random walk with drift and a deterministic trend, which can be seen if we write this equation as
Yt = 1 + 2t + ut (21.5.5a)which means that Yt is nonstationary.

21.6 INTEGRATED STOCHASTIC PROCESSES The random walk model is but a specic case of a more general class of sto-chastic processes known as integrated processes. Recall that the RWM without drift is

7 nonstationary, but its rst difference, as shown in (21.3.8), is stationary. Therefore, we call the RWM without drift integrated of order 1,denoted as I(1). Similarly, if a time series has to be differenced twice (i.e., take the rst difference of the rst differences) to make it stationary, we call such a time series integrated of order 2.15 In general, if a (nonstationary) time series has to be differenced d times to make it stationary, that time se-ries is said to be integrated of order d. A time series Yt integrated of order d is denoted as YtI(d). If a time series Yt is stationary to begin with (i.e., it does not require any differencing), it is said to be integrated of order zero, denoted by YtI(0). Thus, we will use the terms stationary time series and time series integrated of order zero to mean the same thing. Most economic time series are generally I(1); that is, they generally become stationary only after taking their rst differences.

21.7 THE PHENOMENON OF SPURIOUS REGRESSION To see why stationary time series are so important, consider the following two random walk models: Yt = Yt1 + ut (21.7.1) Xt = Xt1 + vt (21.7.2) where we generated 500 observations of ut from ut N(0, 1) and 500 obser-vations of vt from vt N(0, 1) and assumed that the initial values of both Y and X were zero. We also assumed that ut and vt are serially uncorrelated as well as mutually uncorrelated. As you know by now, both these time series arenonstationary; that is, they are I(1) or exhibit stochastic trends. Suppose we regress Yt on Xt . Since Yt and Xt are uncorrelated I(1) processes, the R2 from the regression of Y on X should tend to zero; that is, there should not be any relationship between the two variables. But wait till you see the regression results:

Variable Coefficient C -13.2556 X 0.3376 R2 = 0.1044

Std. error 0.6203 0.0443

t statistic -21.36856 7.61223

d = 0.0121 ( d = Durban Watson statistics)

As you can see, the coefcient of X is highly statistically signicant, and, although the R2 value is low, it is statistically signicantly different from zero. From these results, you may be tempted to conclude that there is a signicant statistical relationship between Y and X, whereas a priori there should be none. This is in a nutshell the phenomenon of spurious or non-sense regression, rst discovered by Yule. Yule showed that (spurious) correlation could persist in nonstationary time series even if the sample is very large. That there is something wrong in the

8 preceding regression is suggested by the extremely low DurbinWatson d value, which suggests very strong rst-order autocorrelation. According to Granger and Newbold, an R2 > d is a good rule of thumb to suspect that the estimated regression is spurious, as in the example above. 21.8 TESTS OF STATIONARITY By now the reader probably has a good idea about the nature of stationary stochastic processes and their importance. In practice we face two impor-tant questions: (1) How do we nd out if a given time series is stationary? (2) If we nd that a given time series is not stationary, is there a way that it can be made stationary? We take up the rst question in this section and discuss the second question in Section 21.10. Before we proceed, keep in mind that we are primarily concerned with weak, or covariance, stationarity. Although there are several tests of stationarity, we discuss only those that are prominently discussed in the literature. In this section we discuss two tests: (1) graphical analysis and (2) the correlogram test. Because of the importance attached to it in the recent past, we discuss the unit root test in the next section. We illustrate these tests with appropriate examples. 1. Graphical Analysis As noted earlier, before one pursues formal tests, it is always advisable toplot the time series under study, as we have done in Figures 21.1 and 21.2for the data given in Table 21.1. Such a plot gives an initial clue about thelikely nature of the time series. Take, for instance, the GDP time series shown in Figure 21.1. You will see that over the period of study GDP hasbeen increasing, that is, showing an upward trend, suggesting perhaps thatthe mean of the GDP has been changing. This perhaps suggests that theGDP series is not stationary. This is also more or less true of the other U.S. economic time series shown in Figure 21.2. Such an intuitive feel is thestarting point of more formal tests of stationarity. 2. Autocorrelation Function (ACF) and Correlogram One simple test of stationarity is based on the so-called autocorrelation function (ACF). The ACF at lag k, denoted by k, is dened as k = k/ 0 (21.8.1)

= covariance at lag k/ variance where covariance at lag k and variance are as dened before. Note that if k = 0, 0 = 1 (why?) Since both covariance and variance are measured in the same units of measurement, k is a unitless, or pure, number. It lies between 1 and +1, as any correlation coefcient does. If we plot k against k, the graph we obtain is known as

9 the population correlogram. Since in practice we only have a realization (i.e., sample) of a stochastic process, we can only compute the sample autocorrelation function (SAFC), k. To compute this, we must rst compute the sample covariance at lag k, k, and the sample variance, 0, which are dened as18 k = 0 =

(Yt Y)(Yt+k Y)/n (Yt Y)2/n

(21.8.2) (21.8.3)

where n is the sample size and Y is the sample mean. Therefore, the sample autocorrelation function at lag k is k = k/0 (21.8.4)

which is simply the ratio of sample covariance (at lag k) to sample variance. A plot of k against k is known as the sample correlogram.

How does a sample correlogram enable us to nd out if a particular time series is stationary?

Figure: 21.8 Let us examine the correlogram of the GDP time series given in Table 21.1. The correlogram up to 25 lags is shown in Figure 21.8. The GDP correlogram up to 25 lags also shows a pattern similar to the correlogram of the random walk model in Figure 21.7. The autocorrelation coefcient starts at a very high value at lag 1 (0.969) and declines very slowly. Thus it seems that the GDP time series is nonstationary. If you plot the correlograms of the other U.S. economic time series shown in Figures 21.1 and 21.2, you will also see a similar pattern, leading to the con-clusion that all these time series are nonstationary; they may be nonstationary in mean or variance or both. Time series results: Data Table 21.1 Page 794

Included observations: 88 Partial Autocorrelation Correlation . |******* . |******* . |******* .|. | 1 2 AC PAC Q-Stat Prob

0.969 0.969 85.4620.000 0.935 0.058 166.020.000

10 0.901 0.020 241.720.000 0.866 0.045 312.390.000 0.830 0.024 378.100.000 0.791 0.062 438.570.000 0.752 0.029 493.850.000 0.713 0.024 544.110.000 0.675 0.009 589.770.000 0.638 0.010 631.120.000 0.601 0.020 668.330.000 0.565 0.012 701.650.000 0.532 0.020 731.560.000 0.500 0.012 758.290.000 0.468 0.021 782.020.000 0.437 0.001 803.030.000 0.405 0.041 821.350.000 0.375 0.005 837.240.000 0.344 0.038 850.790.000 0.313 0.017 862.170.000 0.279 0.066 871.390.000 0.246 0.019 878.650.000 0.214 0.008 884.220.000 0.182 0.018 888.310.000 0.153 0.017 891.250.000 0.123 0.024 893.190.000 0.095 0.007 894.380.000 0.068 0.012 894.990.000 0.043 895.240.000

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3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29

11 0.007 0.019 0.005 895.290.000 0.003 0.002 895.290.000 0.026 0.028 895.380.000 0.046 0.007 895.690.000 0.061 0.047 896.240.000 0.075 0.004 897.080.000 0.085 0.037 898.180.000

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30 31 32 33 34 35 36

The Choice of Lag Length. This is basically an empirical question. A rule of thumb is to compute ACF up to one-third to one-quarter the length of the time series. Since for our economic data we have 88 quarterly observations, by this rule lags of 22 to 29 quarters will do. The best practical advice is to start with sufciently large lags and then reduce them by some statistical criterion, such as the Akaike or Schwarz information criterion that we discussed in Chapter 13.

12

21.9 THE UNIT ROOT TEST A test of stationarity (or nonstationarity) that has become widely popular over the past several years is the unit root test. We will rst explain it, then illustrate it and then consider some limitations of this test. The starting point is the unit root (stochastic) process that we discussed in Section 21.4. We start with Yt = Yt1 + ut whereut is a white noise error term. We know that if = 1, that is, in the case of the unit root, (21.4.1) be-comes a random walk model without drift, which we know is a nonstation-ary stochastic process. Therefore, why not simply regress Yt on its (one-period) lagged value Yt1 and nd out if the estimated is statistically equal to 1? If it is, then Yt is nonstationary. This is the general idea behind the unit root test of stationarity. For theoretical reasons, we manipulate (21.4.1) as follows: Subtract Yt1 from both sides of (21.4.1) to obtain: Yt Yt1 = Yt1 Yt1 + ut = ( 1)Yt1 + ut which can be alternatively written as:
Yt =Yt1 + ut

1 1 (21.4.1)

(21.9.1)

(21.9.2)

, , as usual, is the rst-difference operator. In practice, where = ( 1) and therefore, instead of estimating (21.4.1), we estimate (21.9.2) and test the (null) hypothesis that = 0. If = 0, then = 1, that is we have a unit root, meaning the time series under consideration is nonstationary.

Before we proceed to estimate (21.9.2), it may be noted that if = 0, (21.9.2) will become
Yt =(Yt Yt1) = ut

(21.9.3)

Since ut is a white noise error term, it is stationary, which means that therst differences of a random walk time series are stationary, a point we havealready made before. Now let us turn to the estimation of (21.9.2). This is simple enough; all wehave to do is to take the rst differences of Yt and regress them on Yt1 andsee if the estimated slope coefcient in this regression ( = ) is zero or not .If it is zero, we conclude that Yt is nonstationary . But if it is negative, weconclude that Yt is

13 stationary. The only question is which test we use to find out if the estimated coefficient of nd out if the estimated coefcient of Yt1 in (21.9.2) is zero or not. You might be tempted to say, why not use the usual t test? Unfortunately, under the null hypothesis that = 0 (i.e., = 1), the t value of the estimated coefcient of Yt1 does not follow the t distribution even in large samples; that is, it does not have an asymptotic normal distribution. What is the alternative? Dickey and Fuller have shown that under the nullhypothesis that = 0, the estimated t value of the coefcient of Yt1 in(21.9.2) follows the (tau) statistic.26 These authors have computed thecritical values of the tau statistic on the basis of Monte Carlo simulations.A sample of these critical values is given in Appendix D, Table D.7. Thetable is limited, but MacKinnon has prepared more extensive tables, whichare now incorporated in several econometric packages.27 In the literaturethe tau statistic or test is known as the DickeyFuller (DF) test, in honorof its discoverers. Interestingly, if the hypothesis that = 0 is rejected (i.e.,the time series is stationary), we can use the usual (Students) t test. The actual procedure of implementing the DF test involves several deci-sions. In discussing the nature of the unit root process in Sections 21.4 and21.5, we noted that a random walk process may have no drift, or it may havedrift or it may have both deterministic and stochastic trends. To allow forthe various possibilities, the DF test is estimated in three different forms,that is, under three different null hypotheses.
Yt =Yt1 + ut Yt is a random walk: (21.9.2)
Yt =1 + Yt1 + ut Y t is a random walk with drift: (21.9.4)

Yt =1 + 2t + Yt1 + Y t is a random walk with drift around a stochastic trend: ut (21.9.5)

wheret is the time or trend variable. In each case, the null hypothesis is that = 0; that is, there is a unit rootthe time series is nonstationary. Thealternative hypothesis is that is less than zero; that is, the time series is stationary. Dicky-Fuller Test: Let us return to the U.S. GDP time series. For this series, the results of thethree regressions (21.9.2), (21.9.4), and (21.9.5) are as follows: The dependent variable in Yt = GDPt each case is
= 0.00576GDPt1 GDP t

(21.9.6) d = 1.34 (21.9.7)

t = (5.7980)

R2 =0.0152

= 28.2054 0.00136GDPt1 GDP t

14 t = (1.1576) (0.2191) R2 = 0.00056 d = 1.35

= 190.3857 + 1.4776t 0.0603GDPt1 GDP t

t = (1.8389) (1.6109) (1.6252) R2 = 0.0305

(21.9.8) d = 1.31

Our primary interest here is in the t ( = ) value of the GDPt1 coefcient.The critical 1, 5, and 10 percent values for model (21.9.6) are 2.5897,1.9439, and 1.6177, respectively, and are 3.5064, 2.8947, and 2.5842for model (21.9.7) and 4.0661, 3.4614, and 3.1567 for model (21.3.8). As noted before, these critical values are different for the three models.Before we examine the results, we have to decide which of the three models may be appropriate. We should rule out model (21.9.6) because the coefcient of GDPt1, which is equal to is positive. But since = ( 1), a positive would imply that > 1. Although a theoretical possibility, we rule this case out because in this case the GDP time series would be explosive. That leaves us with models (21.9.7) and (21.9.8). In both cases the estimated coefcient is negative, implying that the estimated is less than 1. For these two models, the estimated values are 0.9986 and 0.9397, respectively. The only question now is if these values are statistically signicantly below 1 for us to declare that the GDP time series is stationary. For model (21.9.7) the estimated value is 0.2191, which in absolute value is below even the 10 percent critical value of 2.5842. Since, in absolute terms, the former is smaller than the latter, our conclusion is that the GDP time series is not stationary. The story is the same for model (21.9.8). The computed value of 1.6252 is less than even the 10 percent critical value of 3.1567 in ab-solute terms. Therefore, on the basis of graphical analysis, the correlogram, and the DickeyFuller test, the conclusion is that for the quarterly periods of 1970 to 1991, the U.S. GDP time series was nonstationary; i.e., it contained a unit root. The Augmented DickeyFuller (ADF) Test In conducting the DF test as in (21.9.2), (21.9.4), or (21.9.5), it was assumed that the error term ut was uncorrelated. But in case the ut are correlated, Dickey and Fuller have developed a test, known as the augmented DickeyFuller (ADF) test. This test is conducted by augmenting the pre-ceding three equations by adding the lagged values of the dependent vari-able Yt . To be specic, suppose we use (21.9.5). The ADF test here consists of estimating the following regression:

Yt = 1 + 2t + Yt1 + i Yt i + t
i =1

(21.9.9)

wheret is a pure white noise error term and where Yt1 = (Yt1 Yt2), Yt2 = (Yt2 Yt3), etc. The number of lagged difference terms to includeis often determined empirically, the idea being to include enough terms sothat the error term in (21.9.9) is serially uncorrelated. In ADF we still test

15 whether = 0 and the ADF test follows the same asymptotic distribution asthe DF statistic, so the same critical values can be used. The Augmented Dicky-Fuller (ADF) test
Null Hypothesis: GDP has a unit root Exogenous: Constant, Linear Trend Lag Length: 1 (Automatic - based on SIC, maxlag=11) t-Statistic Prob.*

Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values.

0.474940848571 -2.214243049 2958 -4.068290085894107 -3.462912333509468 -3.157836346666039

(Level, trend intercept)

Augmented Dickey-Fuller Test Equation Dependent Variable: D(GDP) Method: Least Squares Date: 11/06/12 Time: 09:21 Sample (adjusted): 1970Q3 1991Q4 Included observations: 86 after adjustments Variable Coefficient Std. Error t-Statistic Prob.

GDP(-1) D(GDP(-1)) C @TREND(1970Q1)

0.07866081105631 0.035508178048415 163 49 0.35579411843625 0.102690945389055 71 6 234.972914112337 8 98.58764442917724 1.89219878273842 0.879168264774128 4 5 0.15261494010005 59 0.12161304766469 22 33.6818659414268 6 93026.3836502925 7 422.439232480537 5

0.029513266984 -2.215287164243049 62669 0.000846895207 3.464707789847421 1084719 0.019465203658 2.383391098071484 05546 0.034316872192 2.152260106004348 64463 23.34534883720 93 35.93794212242 164 9.917191453035 755 10.03134714123 359 9.963133828831 874

R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter.

16

To give a glimpse of this procedure, we estimated (21.9.9) for the GDP series using one lagged difference of GDP; the results were as follows:

GDPt = 234.9729 + 1.8921t 0.0786GDPt1 + 0.3557 GDPt1

t = (2.3833) (2.1522) (2.2152) R2 = 0.1526 d = 2.0858 (3.4647) (21.9.10)

The t ( = ) value of the GDPt1 coefcient ( = ) is 2.2152, but this value in absolute terms is much less than even the 10 percent critical value of 3.1570, again suggesting that even after taking care of possible autocorre-lation in the error term, the GDP series is nonstationary. The PhillipsPerron (PP) Unit Root Tests: An important assumption of the DF test is that the error terms ut are independently and identically distributed. The ADF test adjusts the DF test to take care of possible serial correlation in the error terms by adding the lagged difference terms of the regressand. Phillips and Perron use nonpara-metric statistical methods to take care of the serial correlation in the error terms without adding lagged difference terms. Since the asymptotic distribution of the PP test is the same as the ADF test statistic, we will not pursue this topic here. ARIMA Models and the BOX- Jenkins Methodology Questions: 1. Explain what is the implication of behind the AR and MA models by using examples of each. 2. Define the concept of stationarity and state which conditions for statioanrityneed to be present in the AR models . 3. Define and explain the concepts of stationarity and explain why it is important in the analysis of time series data. Present example of statioanrity and non-stationarity The AR(1) Model: The simplest, pure statistical time series models is the autoregssive of order one model, or AR(1), which is given below:
Yt = Yt 1 + u t

This equation states that the behavior of Yt is largely determined by its onw value in the preceeding period. So, what will happen in t is largely dependent on what happened in t-1, or alternatively what will happen in t+1 will be largely be determined by the behavior of the series in the current time t.

17 The AR(p) Model:A generalization of the AR(1) model is the AR(1) model. It will be autoregssive model of order p, and will have p lagged terms as in the following
Yt = 1Yt 1 + 2 Yt 2 +.......... +p Yt p +u t

Or suing the summation symbol: Yt = Yt i + u t

i =1

Properties of AR Models: 1. E (Yt ) = E (Yt 1 ) = E (Yt +1 ) = 0 2 2. Cov( (Yt , Yt 1 ) = 0 The MA(1) Model: The simplest, pure statistical time series models is that of order one, ot the MA(1) , hich has the form :
Yt = u t +u t 1

The implication behind the MA(1) model is that Yt depends on the value of the immediate past error, which is known at time t.

The MA(q) Model:A generalization of the AR(1) model is the AR(1) model. It will be autoregssive model of order p, and will have p lagged terms as in the following
Yt = u t +1u t 1 +2 u t 2 +.......... +p u t q

Or suing the summation symbol: Yt = j u t j

i =1

ARMA models: The combinations of AR(p) and MA(q) is known as the ARMA(p,q) models. The general form of the ARMA (p,q) model is and ARMA(p,q) of the following form:
Yt = 1Yt 1 + 2 Yt 2 +.......... +p Yt p +u t + + 1u t 1 +2 u t 2 +.......... +p u t q

Which can be written, using the summations, as:

Yt = i u t i + u t + j u t j
i =1 j =1

BOX-Jenskins Model Selection:

18 A fundamental idea in the Box-Jenkins approach is the principal of parsimony. Parsimony (meaning sparseness or stinginess) should come as second nature to economists and financial analyst. Incorporating additional coefficients will necessarily increase the fit of the regression equation (i.e. the value of the R 2 will increase), but the cost will be a reduction of the degrees of freedom. Box and Jenkins argue that the parsimonious models produce better forecasts than overparameterized models. In general Box and Jenkins popularized athree-stage method aimed at selecting an appropriate (parsimonus) ARIMA model for the purpose of estimating and forecasting a univariate time series. The three stages are: 1. Identification 2. Estimation 3. Diagnostic checking. Please see the details: In the photocopied sheet Example: The Box-Jenkins Approach File: ARIMA.wf1 Date: 11/12/12 Time: 22:17 Sample: 1980Q3 1998Q2 Included observations: 72 Partial Autocorrelation Correlation . |******* . |******* . |******| . |******| . |******| . |***** | . |***** | . |***** | . |**** | . |******* .*| . .|. .|. .|. .|. .|. .|. .|. | | | | | | | | 1 2 3 4 5 6 7 8 9 AC PAC Q-Stat Prob

0.958 0.958 68.9320.000 0.913 0.067 132.390.000 0.865 0.050 190.230.000 0.817 0.030 242.570.000 0.770 0.013 289.730.000 0.723 0.032 331.880.000 0.675 0.024 369.260.000 0.629 0.022 402.150.000 0.582 0.030 430.770.000

19 10 0.534 0.035 455.310.000

. |**** |

.|.

Date: 11/12/12 Time: 22:17 Sample: 1980Q3 1998Q2 Included observations: 72 Partial Autocorrelation Correlation . |*** | . . . . . |*. |** |** |** |** | | | | | | | | | . |*** | . . . . . |. | |** | |. | |*. | |. | | | | | 1 AC PAC Q-Stat Prob

.|. .*| . .|. .|. .

.*| . .*| . .*| . .|.

0.463 0.463 16.1120.000 2 0.206 0.011 19.3420.000 3 0.289 0.252 25.8140.000 4 0.251 0.033 30.7490.000 5 0.220 0.103 34.5920.000 6 0.225 0.061 38.6710.000 7 0.027 0.198 38.7290.000 8 0.074 0.102 39.1870.000 9 0.041 0.068 39.3270.000 10 0.041 0.019 39.4730.000

Dependent Variable: DLGDP Method: Least Squares Date: 11/12/12 Time: 22:20 Sample: 1980Q3 1998Q2 Included observations: 72 Convergence achieved after 14 iterations MA Backcast: 1979Q4 1980Q2 Variable C AR(1) MA(1) MA(2) MA(3) R-squared Coefficie nt Std. Error t-Statistic Prob. 0.006814 0.001547 0.714711 0.100576 0.452598 0.150094 0.196976 0.128418 0.293634 0.118360 0.336044 Mean 4.403203 0.0000 7.106173 0.0000 -3.015439 0.0036 -1.533867 0.1298 2.480865 0.0156 dependent 0.00594

20 2 dependent 0.00668 7 Akaike info 7.46197 S.E. of regression 0.005609 criterion 7 Sum squared 7.30387 resid 0.002108 Schwarz criterion 5 Hannan-Quinn 7.39903 Log likelihood 273.6312 criter. 6 Durbin-Watson 1.89001 F-statistic 8.477592 stat 2 Prob(F-statistic) 0.000013 Adjusted squared RInverted AR Roots .71 Inverted MA Roots .54+.43i var S.D. 0.296405 var

.54-.43i

-.62

Dependent Variable: DLGDP Method: Least Squares Date: 11/12/12 Time: 22:32 Sample (adjusted): 1980Q3 1998Q2 Included observations: 72 after adjustments Convergence achieved after 9 iterations MA Backcast: 1980Q2 Variable C AR(1) MA(1) R-squared Adjusted squared Coefficie nt Std. Error t-Statistic Prob. 0.006809 0.001464 4.650788 0.0000 0.742293 0.101179 7.336398 0.0000 0.471429 0.161392 -2.921010 0.0047 Mean 0.279356 var RS.D. 0.258468 var

dependent 0.00594 2 dependent 0.00668 7 Akaike info 7.43560 S.E. of regression 0.005758 criterion 3

21 7.34074 2 7.39783 9 1.87620 7

Sum resid

squared 0.002288 Schwarz criterion Hannan-Quinn 270.6817 criter. Durbin-Watson 13.37388 stat 0.000012 .74 .47

Log likelihood F-statistic Prob(F-statistic) Inverted AR Roots Inverted MA Roots