Handbook of Applied Econometrics, Volume 1: Macroeconomics

Handbook of Applied Econometrics

Volume 1: Macroeconomics

Edited by Hashem Pesaran and Mike Wickens

© 1999 by Blackwell Publishing Ltd

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 v

Table of Contents

List of Figures vii

List of Tables ix
List of Contributors xi
Preface xiii
Introduction xv

1 Unobserved Components in Economic Time Series 1

2 Vector Autoregressive Models: Specification, Estimation, Inference,

and Forecasting 53

3 Multivariate Rational Expectations Models and Macroeconometric

Modeling: A Review and Some New Results 111

4 Inventory Models: The Estimation of Euler Equations 157

5 The Consumption Function: A Theoretical and Empirical

Overview 187

6 Large-Scale Macroeconometric Modeling 269

7 The Econometric Analysis of Calibrated Macroeconomic Models 309

8 Macroeconometric Disequilibrium Models 339

9 Financial Market Efficiency Tests 361

 vii

List of Figures

1.1 HP detrended filter (Fourier transform) 5

1.2 X11 seasonally adjusted filter (Fourier transform) 5

1.3 HP trend for t = 70: preliminary and final estimators 6

1.4 Trend extracted from white noise with HP filter 7

1.5 Seasonal component extracted from white noise with X11 8

1.6 Two examples with stable and unstable components 10

1.7 (a) Unstable seasonal series and X11 seasonal component (b)
seasonally adjusted series 10

1.8 (a) Unstable trend series and HP trend (b) detrended series 11

1.9 Two admissible decompositions: (a) series (b) seasonal component (c)
trend (d) irregular 20

1.10 (a) Unstable seasonal and AMB seasonal component (b) seasonally
adjusted series 27

1.11 (a) Trend (b) seasonal 28

1.12 Seasonally adjusted and detrended white noise 36

1.13 Standard error of forecast 42

2.1 VAR recursive residuals 88

2.2 VAR 95% confidence bands 89

viii List of Figures

2.3 VAR probability of a recession 91

2.4 VAR conditional and unconditional forecasts for GNP growth 92

2.5 BVAR recursive residuals 93

2.6 BVAR 95% confidence bands 94

2.7 BVAR probability of a recession 95

2.8 BVAR conditional and unconditional forecasts for GNP growth 97

3.1 Trajectories (log ratios) of actual and model data 139

3.2 Trajectories (log ratios) of Hodrick-Prescott filtered actual and model

data 140

3.3 Trajectories (levels) of Hodrick-Prescott filtered actual and model

data 141

5.1 Log ratio of consumption to income lcey versus dep 242

5.2 dep versus expected income growth dysp and real interest rate
rrm 243

5.3 dep versus income volatility ad and unemployment change dun 243

5.4 dep versus income growth dlryn and change in credit controls
dcch 244

5.5 dep versus weighted wealth to income ratio wwyh and proportion of
middle-aged demom 244

9.1 Log price and log dividend 365

9.2 Valu-weighted monthly real returns 370

9.3 Log price/dividend ratio 383

 ix

List of Tables

1.1 Underestimation of the component 𝐕𝐚 = 𝟏 29

1.2 Variance of the Stationary transformation of the estimator 30

1.3 Crosscorrelation between the stationary transformations of the

estimators 31

1.4 AR fits to US GNP seasonally adjusted (rate of change) 34

1.5 Variance of estimation errors: concurrent estimator

(in units of Va ) 41

1.6 Standard error of the rate of growth: concurrent estimator

(in % of annualized growth) 44

2.1 Unit roots and cointegration tests of the log of the variables: sample
1955/1 to 1986/4 86

2.2 Diagnostic tests on the VAR residuals: sample 1955/1 to 1986/4 86

2.3 VAR covariance and Granger results 87

2.4 Diagnostic tests on the BVAR residuals: sample 1955/1 to 1986/4 90

2.5 BVAR covariance and Granger results 96

4.1 Cost parameters for data generating processes 162

4.2 Comparison of asymptotic variance-covariance matrices resulting

from optimal and 2SLS linear combinations of instruments 163

4.3 Asymptotic sizes of nominal 0.05 tests, when an inconsistent

estimator of the 2SLS covariance matrix is used 164
x List of Tables

4.4 Asymptotic bias of full information estimator, when sales are

endogenous 174

4.5 Comparison of asymptotic variance-covariance matrices of limited

and full information estimators 175

4.6 Statistical significance of cost variables 180

5.1 Response of permanent to current income 206

5.2 Revisions in UK data on consumer expenditure and saving 246

7.1 Differences between SEA and CA 316

7.2 Bias in estimators of RBC model parameters 319

7.3 Business cycle characteristics of selected processes 325

7.4 Sensitivity elasticities for output variance ratio in BER’s model 331

9.1 Real monthly percentage returns, short-horizon summary

statistics 370

9.2 Real monthly returns, MA(1)-GARCH(1,1) quasi-maximum-likelihood

estimates 373

9.3 Real monthly returns, multi-period regressions 377

9.4 Real monthly returns, one-period regressions 380

9.5 Real monthly stock prices and dividends 382

9.6 Volatility tests 386

 xi

List of Contributors

Michael Binder University of Maryland

Tim Bollerslev Northwestern University, Evanston, IL
Fabio Canova Universitat Pompeu Fabra, Barcelona
Robert J. Hodrick Northwestern University, Evanston, IL
K. Kim Victoria University of Wellington, Wellington
Guy Laroque INSEE, Paris
Ralph Lattimore Department of Industry, Canberra
Agustín Maravall European University Institute
M. Hashem Pesaran University of Cambridge
John Muellbauer Nuffield College, Oxford
A. R. Pagan Australian National University, Canberra
Bernard Salanié ENSAE, Paris
Kenneth F. Wallis University of Warwick, Coventry
Kenneth D. West University of Wisconsin, Madison
Mike Wickens University of York, York
 xiii

Preface

This volume launches a series of handbooks which aims to survey the latest develop-
ments in the various areas of applied econometrics, both at micro and macro levels. In
preparing this volume we have benefitted greatly from the help and advice of the mem-
bers of the Advisory Committee of the series, Jerry Hausman, Edward Leamer, Adrian
Pagan, Richard Quandt and Lawrence Summers.
In addition, we would like to thank Frank Diebold, Clive Granger, Jim Hamilton, Brian
Henry, Kevin Lee, Helmut Lutkepohl, Hassan Molana, Peter Schmidt, Ron Smith and
Ken West for helpful comments on draft chapters.
Finally, we would like to acknowledge the full support of Blackwell in this venture. We
are also grateful for expert secretarial help from Gill Smith at all stages of the preparation
of this volume.
 xv

Introduction
M. Hashem Pesaran1 and M. R. Wickens2
1
University of Cambridge
2
University of York, York

This is the first volume in what is planned to be a regular series of handbooks survey-
ing the latest developments in applied econometrics. This volume covers topics related
to macroeconomics and finance, and a companion volume will cover topics in the field
of microeconometrics.1 The emphasis of the series will be on rigorous applications of
econometric and statistical methods to economic problems, and the methodological
issues that arise from such applications, not on contributions of econometric and sta-
tistical theory. The impetus for this series comes from our perception that there is a
body of knowledge about the problems of undertaking empirical work in the field of
economics, and in general this knowledge is common to more than one application area.
As a result, especially in this volume, the concern will not be with specific applications,
although this distinction is bound to become blurred because each application area has
a tendency to generate its own methodological problems.
There is, of course, no agreement over the appropriate methodology to use in applied
work, and this is particularly applicable to empirical research in macroeconomics. There
are currently five major approaches to macroeconometric modeling: the traditional
Cowles Commission structural equations approach, unrestricted and Bayesian VARs,
“structural” VARs, linear rational expectations models, and the calibration approach
associated with real business cycle theories. In all these approaches, the main area of
disagreement is over the relative roles of economics and statistics: should one aim to
estimate a model derived from formal economic theory, or is it sufficient to find a model
that accords well with the data? (On this, see also Pesaran and Smith, 1995) Compared
with the natural sciences, where applied work has a profound influence in setting the
theoretical agenda by uncovering empirical puzzles that require new theoretical tools
to deal with them, in economics, notwithstanding data problems, applied research does
not receive the attention that it deserves. The lack of a widely accepted methodological
framework for applied economics is a major reason for this. In this handbook series we
aim to provide a timely corrective by examining the many problems associated with
bringing empirical evidence to bear in economics.
In this volume various methodological issues, more or less peculiar to applied macroe-
conometrics, are discussed, either explicitly or implicitly: the source of the stochastic
structure of economic models, and especially the role of expectations; the stochastic
xvi Introduction

properties of economic data and the implications for modeling, estimation, and test-
ing; the role of economic theory in model building and the relation between statistical
models and economic theory; equilibrium and disequilibrium models; the best way to
bring evidence to bear; classical statistical methods or calibration, and the connection
between the two; and forecasting with large models. It is planned that future volumes
will add to this list of topics.
In applied econometrics there is a continual tension between the requirements of eco-
nomic theory and the need to take account of the properties of the data. A theory that
predicts a relation between variables with very different time series properties will often
result in econometric models that have poor empirical properties: trying to explain a
nonstationary series with a stationary series, or a seasonally adjusted series by a season-
ally unadjusted series, are two examples. An understanding of the properties of the time
series observations is therefore essential at the outset. In chapter 1 Agustín Maravall dis-
cusses the characteristics of economic time series from the perspective of unobserved
component models. A study of unobserved component models can be justified in its
own right as they have been used widely in macroeconomics. Two notable examples are
the permanent income hypothesis and real business cycle theory. They are also used in
short-term policy analysis, and trend and seasonal analysis. The chapter begins with a
discussion of linear filters, and points out some of the dangers of the application of ad hoc
filters to economic time series data. For example, using filters like the Hodrick-Prescott
filter for trend removal or the X11 filters for seasonal adjustments may result in a pro-
cess with very different characteristics from those that are wanted or even anticipated.
To make matters worse, the filtered values may change as new observations are added
to the data set. An alternative approach is to base seasonal adjustment or detrending of
economic time series on parametric models such as the ARIMA model. This does not
solve the problem entirely, however, as there is no agreement on the best way to model
the components. The ensuing discussion on alternative ways of modeling the trend, sea-
sonal, cyclical, and irregular components illustrates this. The chapter then turns to a
discussion of the identification of one component from another, showing how additional
restrictions can resolve the problem and using US GNP to provide an empirical example.
This example helps to explain the common finding that within the class of linear models,
a simple model is usually found to be adequate for US GNP.2
Having specified the components model, the next step is to estimate it. There follows a
discussion of the determination of the optimal estimator and its implications for econo-
metric analysis. These include the dangers of using detrended or deseasonalized data
in econometric models, and using finite VAR models when the filter is invertible. The
chapter concludes by warning against the use of seasonally adjusted series in economet-
ric modeling and advances the view also emphasized by others, notably by Ken Wallis,
that seasonality needs to be modeled explicitly in empirical analysis.
The VAR model was initially introduced into econometrics as a response to the dif-
ficulties surrounding the identification of the structural models favored by the Cowles
Commission approach. The unrestricted VAR model and its various restricted deriva-
tive models are now among the most widely used time series models in macroecono-
metrics. As a result of introducing restrictions into the VAR, the distinction between
structural models and time series models has become blurred. More recently, the coin-
tegrated VAR (or VECM) has been used intensively in the analysis of nonstationary time
series instead of structural systems. In chapter 2 Fabio Canova provides a comprehensive
 Introduction xvii

review of these developments. The chapter is therefore a complement to the univariate

analysis presented in chapter 1. Canova starts by discussing various specification and
estimation issues such as the ability of the VAR to represent a more general multivari-
ate time series model and the related problem of how to choose the lag length. He also
considers Bayesian specifications of the VAR (the BVAR) and its connection with the
Kalman filter. Next he discusses how the VAR has been constrained to reflect the restric-
tions of economic theory. This method is widely used in the estimation and testing of
real business cycle models (see chapter 7).
VAR analysis is commonly used as an atheoretical way of estimating the dynamic
impact of economic shocks. Unfortunately, as with the structural systems approach it
originally sought to replace, VARs suffer from a largely intractable identification prob-
lem that requires the use of, often arbitrary, restrictions. Canova examines various ways
of achieving identification for stationary and nonstationary data. These include orthogo-
nalization and alternative ways of bringing structural information to bear by exploiting
short-run and long-run restrictions. He discusses the importance of this problem for
testing exogeneity and causality, and for the variance decomposition of shocks. Another
use of VAR analysis is for forecasting, both unconditional forecasting, which is the stan-
dard approach and is uncontroversial, and conditional forecasting, which is more prob-
lematical as it requires structural restrictions, and is subject to the Lucas critique. Of
course, as Canova points out, once a priori information is used to identify a VAR, the
distinction between the VAR modeling strategy and the standard simultaneous equation
approach becomes a matter of degree, not of content. The issue then centers on the
choice of a priori restrictions to be imposed on the VAR, and the extent to which they
can be viewed as credible. Canova also discusses various recent methodological criti-
cism of VAR analysis: the problems with using detrended, seasonally adjusted, or aggre-
gated data; the fragility of VAR models for causality analysis; the effects of using a VAR of
too low dimension; and the problems of using a VAR for policy analysis and the related
implications of rational expectations and changes of policy regime. Finally, he provides
an empirical application to illustrate many of his arguments, by estimating a trivariate
VAR for the GNPs of the USA, Japan, and Germany.
There is a long history in econometrics of the modeling of expectations. In early work
the expectations formation processes used in macroeconomic analysis tended to be ad
hoc. Partly for estimation convenience, schemes such as static and adaptive expectations
were widely adopted, even though they usually had the disadvantage of implying that
economic agents made systematic mistakes. Although rational expectations is a very
strong assumption, it has the merit of endogenizing expectations in a model-consistent
manner, thereby putting expectations formation on the same footing as the rest of
the model. For example, in a dynamic intertemporal optimizing framework, where
the optimand contains lagged decision variables, the first-order conditions (or the
Euler equations) will involve expectational variables that satisfy the requirement
of the rational expectations hypothesis. These can be solved for, and the rational
expectations variables solved out of the model, or the Euler equations can be estimated
directly together with the constraints. Either way the rationally expected variables
will be a function of the structural parameters – as well as the other variables in the
model – and so efficient estimation of the structural parameters will require the use of
this information. It will therefore be necessary to use nonlinear estimation methods.
xviii Introduction

Whichever approach to estimation is chosen, the rational expectations solution will be

needed either explicitly, or implicitly in the estimation process.
In chapter 3 Michael Binder and Hashem Pesaran survey existing rational expecta-
tions solution methods and suggest a new, more general yet straightforward procedure
capable of handling both current and future expectations variables which is also appli-
cable in a multivariate context. The proposed method decomposes the solution into a
backward and a forward component and uses a martingale difference technique to solve
the forward component. The proposed solution method provides a complete characteri-
zation of all the possible classes of solutions (namely the unique stable solution, multiple
stable solutions, and the case where no stable solution exists), and allows the incorpora-
tion of many forms of nonstationarity and non-linearity of the model’s forcing variables.
It also produces a convenient VAR framework for the purposes of full information esti-
mation and the analysis of the cointegration properties of multivariate linear rational
expectations models. Two applications of the proposed method are given. One is for the
small, standard real business cycle model of Christiano and Eichenbaum (1992) in which
a comparison is made with other methods. Estimates of the model based on Christiano
and Eichenbaum’s data are presented. The other is an application to a broad class of
dynamic optimization models of consumers’ and/or firms’ behavior in which complete
characterization of the solution is analyzed. This model is not estimated. The chapter
concludes with a brief review of three other important recent developments in the ratio-
nal expectations literature not covered in this volume, namely learning, heterogeneous
information and multivariate nonlinear rational expectations models.
Another important strand in the rational expectations literature is how to estimate
Euler equations. In chapter 4 Kenneth West discusses this problem in the context of
econometric models of inventory behavior, but the results have general applicability.
He considers the linear quadratic model first used to analyze inventories by Holt et al.
(1960). This model has also been widely applied to other problems (see also the mul-
tivariate adjustment cost example in chapter 3). Expected discounted net revenues are
maximized subject to a quadratic cost function that depends on the level of output, its
rate of change, the excess of inventories over sales and two stochastic terms which are
proportional to the levels of output and inventories. This specification has the advan-
tage of producing a first-order (Euler) condition with an intrinsic linear stochastic term.
There is, therefore, no need to add a stochastic term to the Euler equation to produce an
estimating equation as this is already included in the underlying optimization problem.
As in most other studies of this type, the value of the discount rate is imposed a priori
and not estimated.
Two approaches to the estimation are considered: a limited information approach,
which avoids making any assumptions about the demand function; and a full informa-
tion approach in which a demand function is specified and the estimating equation is
the solution for the firm’s equilibrium decision rule. The limited information estima-
tion considers the choice of instruments, the estimation of the covariance matrix, and
the implications of the presence of unit roots in the process of the forcing variables.
The main complication here is that the disturbance term is a composite of current and
expected future innovations, which presents problems both for finding (or construct-
ing) instruments that are asymptotically uncorrelated with the disturbance term and
suitably correlated with the regressors, and for the estimation of the covariance matrix.
 Introduction xix

It is concluded that the usual tradeoff between full and limited information estimation
methods is relevant here, namely, gains in efficiency versus computational complexity.
The chapter ends with a discussion of some existing empirical evidence, and, in par-
ticular, the common finding that inventories are procyclical and highly serially corre-
lated. West observes that this is consistent with the cost function either being negatively
related to the level of output, or having a large accelerator effect. He finds that existing
evidence does not resolve the issue and that perhaps microeconomic evidence may be
of help.
There are probably more econometric studies of the aggregate consumption function
than of any other macroeconomic relation. This is because the consumption function is
one of the main building blocks of the Keynesian model which is still the basis of most
macroeconometric models. Despite this attention, there is still no settled view of how
aggregate consumption should be modeled. The consumption function is an excellent
example of the tendency, noted above, for applied econometrics to make more use of for-
mal economic theory in constructing models. In the case of the consumption function,
life-cycle theory has become the dominant theoretical framework. As with inventories,
this has meant a concern for intertemporal optimization, the use of rational expecta-
tions, and a debate about whether it is better to estimate the associated Euler equation
than the traditional (solved) consumption function. In chapter 5, John Muellbauer and
Ralph Lattimore take a wide-ranging and critical look at the construction of consump-
tion functions based on life-cycle theory.
They begin by deriving the standard two-period optimization model, and then extend
this to many periods. Age and family effects, which are important for aggregation, are
also considered. Using this framework, they then turn to a discussion of the stochastic
structure of consumption and income and their interconnection – issues that have occu-
pied much of the recent consumption function literature and draw heavily on the the-
ory of nonstationary stochastic processes. Muellbauer and Lattimore provide a detailed
analysis of the “excess sensitivity” and “excess smoothness” debate – i.e. why consump-
tion appears to overrespond to anticipated changes in income, yet the variance of the
growth in consumption is low relative to that of income – which further advances our
understanding of the problems involved.
Muellbauer and Lattimore then turn to a discussion of the potential importance of
income volatility and skewness for consumption and savings, how this might affect the
appropriate rate of discount, and the implications for solving consumption from the
Euler equation. Another finding not consistent with standard life-cycle theory is that
changes in consumption are partly forecastable. Various explanations are suggested.
One is that credit constraints induce an error-correction-type structure. Other expla-
nations discussed are interactions between leisure and consumption, the presence of
durable goods, the failure of the assumption of rationality, and aggregation. Finally, the
practical implications of their previous arguments are drawn together and used to sug-
gest how one might formulate econometric models of consumption. The authors take
account of nonlinearities in functional form, a variable interest rate, credit constraints,
and the effect of financial liberalization. They then comment on recent empirical work
that embraces some of these features. This substantial chapter is completed with a dis-
cussion of data issues, including the measurement problems both in household surveys
and in aggregate time series data.
xx Introduction

Under the influence of the rational expectations hypothesis and the Lucas critique,
large-scale macroeconometric modeling has undergone significant transformations, but
still remains an important tool in economic forecasting and macroeconomic policy anal-
ysis. In chapter 6 Kenneth Wallis, drawing from his practical experiences at the Macroe-
conomic Modelling Bureau at the University of Warwick, provides a comprehensive
account of the current state of the art of large-scale macroeconometric modeling. The
chapter begins with a brief survey of some of the more important recent developments
in the structures of macroeconomic models, especially those constructed for the US and
UK economies. However, the main focus of the chapter is on various technical issues and
the available methods of dealing with them. Three areas are considered: the evaluation
of forecasts, the use of forecasts to evaluate models, and the use of stochastic simulation
methods in the analysis of large-scale models incorporating rational expectations.
The discussion relating to forecasting considers the testing of forecast unbiasedness
and efficiency, the combining of forecasts from different models or methods, the sources
of forecast error, and the use of residual adjustments. The section on stochastic simula-
tion provides a detailed description of the issues involved, including a discussion of the
experimental design, the treatment of nonlinearities, and the usefulness of deriving vari-
ance measures. The examination of rational expectations in macroeconometric models
focuses on model consistent solutions and comments on some of the implications for
optimal control experiments. The implementation of rational expectations in large non-
linear macroeconometric models is still in its infancy. It raises a number of new issues
for modelers, such as the time horizon, the information set assumed, and the treatment
of nonlinearities. The chapter ends with a discussion of some of these questions.
Calibrated macroeconomic models have emerged in recent years as a major chal-
lenge to both the conventional system equation macroeconometric and VAR modeling
approaches. Initially, under the influence of the pioneering work of Kydland and Prescott
(1982), the primary emphasis of this approach was on “quantitative theory,” where the-
ory was the focus of the analysis, often at the expense of measurement. However, over
the past decade important attempts have been made to place this approach in the context
of traditional macroeconometric analysis, and chapter 7 by K. Kim and Adrian Pagan
provides a systematic treatment which will go a long way towards defining the issues
to be resolved and to answering many of the questions that have already arisen. Unlike
previous commentators, Kim and Pagan highlight the similarities as well as the differ-
ences between the Cowles Commission system equation approach and the calibration
method. They propose adopting the following five criteria that are familiar in traditional
econometrics: specification, estimation, goodness of fit, quality, and usage of models.
They argue that calibration is best thought of as an alternative research style which can
be distinguished by its approach to four specification issues: whether the model pos-
sesses a steady state, the information available to agents, the dynamic specification, and
the nature of the exogenous (forcing) variables. Calibrated models are often constructed
from an intertemporal optimization and, as a result, have dynamics that are intrinsic,
for example arising from the stock – flow relations implicit in the budget constraints.
But they can also usually be represented as a VAR whose coefficients are a function of
the deep structural parameters of the original optimization problem, and whose vari-
ables may be unobservable. Throughout their analysis Kim and Pagan heavily exploit
this connection between the two approaches.
 Introduction xxi

Next they discuss how models are calibrated, and compare estimation procedures
based on matching unconditional moments with the more formal statistical procedures
such as the generalized method of moments (GMM) and the maximum likelihood esti-
mation methods that exploit conditional moment properties. A large part of the chapter
is devoted to a discussion of assessing how well a calibrated model performs. Various cri-
teria are considered such as replicating stylized facts of the time series properties of key
variables (especially business cycle features), parameter restrictions, impulse response
functions, and univariate representations of key variables. They note that errors in vari-
ables and the use of filtered data in the analysis of calibrated models can add considerably
to the difficulties of their assessment. The chapter ends with a discussion of the sensi-
tivity of calibrated models to parameter variation.
Modeling disequilibrium or the phenomenon of nonmarket clearing, with agents
being constrained on one side of the market, provides a number of new conceptual
problems for applied econometricians, as well as a different setting for many of the
standard concerns. Guy Laroque and Bernard Salanié provide a review of the main
issues in chapter 8. Their discussion is confined to market economies; the literature on
planned economies is not covered.
They begin with a discussion of the most commonly studied case of static markets with
fixed prices, without spillover effects, but with possible problems of aggregation across
markets. These models have usually been estimated by maximum likelihood methods
(either limited, full or pseudo maximum likelihood) but, as Laroque and Salanié note,
simulation-based methods have recently been tried with some success. These are often
less efficient but have the advantage of being more flexible, especially where closed-form
solutions are either difficult or impossible to obtain. Apart from estimation, they touch
on several specification issues, such as whether the regime (i.e. whether the market is
demand or supply constrained) is known or unknown and requires estimation, the use of
surveys to help resolve this, the functional form of the errors, and the relation between
quantity and the demand and supply functions. They then review the empirical literature
for these models.
Early work on disequilibrium models was often criticized for treating prices as given,
and for ignoring the effect of price expectations and other dynamics. Laroque and
Salanié next turn to a discussion of recent work on these problems. They comment
favorably on the usefulness and good performance of simulation methods in the
estimation of dynamic disequilibrium models. They close the chapter with a number of
observations on areas where future work might successfully be directed. One of these
is to take account of the econometric and specification problems that arise from the
use of nonstationary data. At present there is virtually no work on this topic. They also
remark on the need to model expectations, and taking better account of the role of
inventories and buffer stocks.
Financial econometrics is another excellent example of how applied econometrics has
led to new methodological developments in economics and econometrics. The different
nature of much of financial data (they typically display different higher-order moments
than conventional economic data and they are often nonstationary), the need for mea-
sures of new concepts (for example, volatility, present values, bubbles), for new estima-
tors, and for new tests, and the puzzles thrown up by the empirical results, have all con-
tributed to this. These considerations are very much in evidence in chapter 9 in which
Tim Bollerslev and Robert Hodrick consider the problem of testing the efficiency of
xxii Introduction

financial markets. They adopt a different approach to the other chapters. Instead of sur-
veying the large number of published studies that exist, they have undertaken a system-
atic empirical analysis of the ability of different models to explain the distribution and, in
particular, the temporal dependence of monthly data on the NYSE value-weighted price
index. This is used as a vehicle to illustrate many of the alternative econometric tests
and estimation procedures that are available for testing market efficiency. Their gen-
eral conclusion is that a rational explanation of the behavior of stock returns requires
an understanding of the link between conditional volatility of market fundamentals and
the variability of expected returns.
The value of a test of market efficiency will depend on how good an explanation of
the behavior of asset returns is provided by the underlying model. In common with
most high-frequency financial data, the returns on the NYSE price index are character-
ized by periods of tranquility followed by periods of turbulence. Bollerslev and Hodrick
provide a set of descriptive statistics for the stock index and then examine how well sim-
ulations of various models are capable of replicating these characteristics. These models
are all based on alternative versions of the present value model of the relation between
a stock price and expected future dividends, with real dividends being forecast either by
an autoregressive or by a GARCH model. The basic model assumes a constant discount
rate and no GARCH effects. Two variations on this are provided by adding a stochastic
process to the fundamentals. One is the fads model in which the process added is sta-
tionary and serially correlated. The other is the (collapsing) bubbles model in which the
process is nonstationary. Models with GARCH effects in the dividend process, and some
specific formulations of time-varying discount rate, are also considered by Bollerslev
and Hodrick. They find that over the period January 1928 through December 1987
actual monthly returns have strong dependence due to highly significant conditional
heteroskedasticity, rather than serial correlation, which is mild. The returns also have
significant positive skewness and pronounced leptokurtosis due to the heteroskedastic-
ity in the dividend process. Using simulations of the various models, only the GARCH
and time-varying discount rate models come close to replicating the behavior of actual
returns, especially the volatility clustering.
The chapter then turns to long-run evidence on stock market predictability. The first
question addressed is the predictability of future returns from current returns over alter-
native horizons ranging from 1 to 48 months for each of the various models. It is found
that the results are sensitive to the forecast horizon, but not in any systematic way,
suggesting that there may be small-sample problems with the distributions of the test
statistics. After investigating different ways of estimating the models, and correcting the
test statistics, the general conclusion to emerge is that past returns are not statistically
significant in predicting future returns. This conclusion is reached using information
on lagged prices and dividends, and may be contrasted with that of other studies, for
example by Breen, Glosten, and Jagannathan (1990), Campbell, (1987), Fama and French
(1989), Sentana and Wadhwani (1991), Granger (1992), and Pesaran and Timmermann
(1995, 1994) which find much stronger statistical evidence of the predictability of excess
returns (over short as well as long horizons) when other information such as lagged
interest rates, output growth, or inflation are also included in the analysis.
Unlike studies based on annual data, a cointegration analysis of real stock prices and
real dividends on these monthly data do not reject the cointegrating vector (1, −1), but
do reject the presence of a bubble. The study ends by performing a volatility test. The
 References xxiii

particular test chosen is a variant of that by Mankiw, Romer, and Shapiro (1991) which
is based on a comparison of the actual and the ex post rational stock price, the latter
being constructed by discounting actual dividends for a finite horizon. For all of the
models, except the model with a time-varying discount rate, the p-values are small, indi-
cating rejection of the standard asset pricing model. It is inferred from this – and this is
supported by further tests – that the time-varying discount rate model contains infor-
mation, such as the current level of dividends, time variation in the conditional variance
of dividends, and a variable discount rate, that is relevant to portfolio decisions.
Clearly, no single volume could do justice to the wide variety of topics that are cur-
rently of interest in applied macroeconometrics. Important areas of research not cov-
ered in this volume include recent developments in growth theory, international trade
and finance, and nonlinear dynamic modeling. Nevertheless, the included chapters pro-
vide a rich selection of the techniques that are currently in use in macroeconometrics.

Notes
1 Volume II of the handbook is edited by Pesaran and Schmidt and includes chapters on
consumer demand (Lewbel), labor supply (Blundell), search and dynamic event history
models (Neumann), inequality and welfare (Maasoumi), household firm models (Pitt),
analysis of business surveys (Zimmermann), measurement of productivity (Berndt and
Fuss), frontier production functions (Greene), and models of count data (Wooldridge).
2 This is not, however, necessarily the case once the linearity assumption is relaxed. See,
for example, Potter (1995) and Pesaran and Potter (1994).

References
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Campbell, J. Y. (1987), Stock Returns and the Term Structure, Journal of Financial
Economics, 18, pp. 373–99.
Christiano, L. J. and M. S. Eichenbaum (1992), Current Real-Business-Cycle Theories and
Aggregate Labor-Market Fluctuations, American Economic Review, 82, pp. 430–50.
Fama, E. F. and K. R. French (1989), Business Conditions and Expected Returns on Stocks
and Performance, Journal of Business and Economic Statistics, 10, pp. 461–5.
Granger, C. W. J. (1992), Forecasting Stock Market Prices: Lessons for Forecasters,
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Holt, Charles C., Franco Modigliani, John F. Muth and Herbert A. Simon (1960), Planning
Production, Inventories and Work Force, Englewood Cliffs, NJ, Prentice-Hall.
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Volatility: A Statistical Appraisal, Review of Economic Studies, 58, pp. 455–77.
Pesaran, M. H. and Simon M., Potter (1994), A Floor and Ceiling Model of UK Output, DAE
Working Paper no. 9407, Department of Applied Economics, University of Cambridge.
xxiv Introduction

Pesaran, M. H. and R. Smith (1995), The Role of Theory in Econometrics, Journal of

Econometrics, 67, pp. 61–79.
Pesaran, M. H. and A. Timmermann (1994), Forecasting Stock Returns: An Examination of
Stock Market Trading in the Presence of Transaction Costs, Journal of Forecasting, 13,
pp. 335–67.
Pesaran, M. H. and A. Timmermann (1995), Predictability of Stock Returns: Robustness
and Economic Significance, Journal of Finance (forthcoming).
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Econometrics, 10, pp. 109–25.
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of Stock Market Returns, Some Lessons from Japan, Review of Economic Studies, 58, pp.
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