Advanced Econometrics: Based On The Textbook by Verbeek: A Guide To Modern Econometrics

Univariate time series Multivariate time series Panels
Advanced Econometrics
Based on the textbook by Verbeek:
A Guide to Modern Econometrics
Robert M. Kunst
robert.kunst@univie.ac.at
University of Vienna
and
Institute for Advanced Studies Vienna
May 2, 2013
Advanced Econometrics University of Vienna and Institute for Advanced Studies Vienna
Outline
Univariate time series
Multivariate time series

General concepts
Cointegration
Vector autoregressions
Multivariate cointegration
Panels
General concepts
Issues with multivariate time series
◮ Regressing integrated variables on other integrated variables

often yields apparently significant coefficients (even if there is
no relation) and integrated residuals: spurious regression;
◮ If residuals are stationary, the relation may be an important
dynamic equilibrium: cointegration;
◮ Cointegration is closely related to the dynamic mechanism
that is directed toward the equilibrium: error correction;
◮ The multivariate generalization of the autoregressive model is
the vector autoregression (VAR), which sets a convenient
frame for cointegration, causality etc.
General concepts
A simple dynamic model
Consider two stationary variables Y and X , with X regarded as

exogenous, related by an autoregressive distributed lags (ARDL)
model
Yt = δ + θYt−1 + φ0 Xt + φ1 Xt−1 + εt ,
with white-noise εt and |θ| < 1. The entity
∂Yt
= φ0
∂Xt
is called the impact multiplier.
General concepts
The equilibrium multiplier

Straightforward evaluation yields
∂Yt+1
= θφ0 + φ1
∂Xt
and
∂Yt+2 ∂Yt+1
=θ = θ(θφ0 + φ1 )
∂Xt ∂Xt
The sum of all these multipliers describes the long-run effect

∞
X ∂Yt+j θφ0 + φ1 φ0 + φ1
= φ0 + = ,
∂Xt 1−θ 1−θ
j=0
the long-run multiplier or equilibrium multiplier β.

General concepts
Error correction
X and Y are stationary, for this reason

δ
E(Yt ) = + βE(Xt ) = α + βE(Xt )
1−θ
for some constant α. Some manipulation yields
∆Yt = φ0 ∆Xt − (1 − θ)(Yt−1 − α − βXt−1 ) + εt ,
an error-correction model: Y adjusts to deviations from

equilibrium, with 1 − θ representing the intensity of adjustment.
General concepts
Generalizations to higher lag orders

Assume the general form
θ(L)Yt = δ + φ(L)Xt + εt ,
with lag polynomials of orders p and q and invertible θ(z).

Applying the inverse operator θ −1 (L) yields
Yt = θ −1 (L)φ(L)Xt + θ −1 (L)εt ,
and the long-run multiplier becomes

φ0 + φ1 + . . . + φq
θ −1 (1)φ(1) = ,
1 − θ1 − . . . − θp
with the denominator positive because of stability.

Cointegration
The basic experiment of spurious regression

Presume Xt and Yt are independent random walks. The regression
Yt = α + βXt + error
tends to produce significant coefficients and non-zero R 2 . Flanking

diagnostics such as the Durbin-Watson statistic tend to indicate
that something is wrong. In fact, the residual is I(1) by
construction.
To avoid spurious regression, first subject Y and X to unit-root
tests. If these tests support the null of I(1), test residuals. If
unit-root tests on residuals fail to reject, we have a spurious
regression problem. Note, however, that the usual Dickey-Fuller
significance points are invalid for residual unit-root tests.
Cointegration
Non-spurious regression with integrated variables
Consider two I(1) variables Yt and Xt , with Yt − βXt stationary

I(0). Then, Y and X are said to be cointegrated. The regression
Yt = α + βXt + error
yields a coefficient estimate β̂ that is super-consistent for β, i.e.

√
T (β̂ − β) → 0, T (β̂ − β) ⇒ D,
with a non-standard limit distribution D. Note that errors are I(0)

but they are usually not white noise here. This regression is called
a cointegrating regression.
Cointegration
Cointegration with two variables
Definition
If Yt and Xt are both I(1) and there exists a β such that
Zt = Yt − βXt is I(0), then X and Y are cointegrated and
(1, −β)′ is the cointegrating vector.
The cointegrating relation can be interpreted as a long-run

equilibrium in a non-stationary dynamic model, and the model can
also be written as an error-correction model (see below).
Cointegration
Testing for cointegration in a simple regression

In order to determine whether the regression is spurious or
cointegrating, it is recommended to first test X and Y for unit
roots. If the unit-root tests fail to reject, run the regression (no
lags!) and apply unit-root tests to residuals. Use different
significance points from the usual DF test. Appropriate significance
points have been calculated by Phillips & Ouliaris, for
example.
◮ If the residual unit-root test rejects, there is evidence on

cointegration;
◮ If the residual unit-root test fails to reject, the regression is
spurious.
Cointegration
Cointegration and error correction
Engle & Granger have shown that, if X and Y are

cointegrated, then there exists an error-correction representation
θ(L)∆Yt = δ + φ(L)∆Xt−1 − γZt−1 + α(L)εt ,
with Zt = Yt − βXt . If Y deviates positively from the equilibrium

at t − 1, ∆Y corrects back to it at t by being smaller than usual,
and similarly for negative deviations. X could also adjust, but this
can only be captured in a full multivariate model.
Vector autoregressions: the concept

The vector autoregressive model (VAR) is a multivariate
generalization of the univariate AR model: variables are vectors,
coefficients are matrices:
Yt = δ + Θ1 Yt−1 + . . . + Θp Yt−p + εt ,
with Yt , Yt−1 , . . . , Yt−p , εt , δ k–vectors and Θj , j = 1, . . . , p

k × k–matrices. The lag polynomial is now a matrix polynomial
Θ(L) = Ik − Θ1 L − . . . − Θp Lp ,
with Ik denoting the k–dimensional identity matrix. In short, we

write
Θ(L)Yt = εt .
Stationarity of multivariate processes
In analogy to the univariate case, the vector variable Yt is said to

be (covariance) stationary, iff
◮ EYt = µ = (µ1 , . . . , µk )′ ;
◮ E(Yt − µ)(Yt − µ)′ = varYt = ΣY ;
◮ E(Yt − µ)(Yt−h − µ)′ = cov(Yt , Yt−h ) = Γ(h).
The matrix-valued function Γ(h) is the cross-covariance function,

its standardized version is the cross-correlation function (CCF). It
is skew symmetric, i.e. Γ(h)′ = Γ(−h). Also note that Γ(0) = ΣY .
Multivariate white noise
A k–dimensional variable (εt ) is said to be white noise, iff

◮ εt is stationary;
◮ Eεt = (0, . . . , 0)′ ;
◮ Γ(h) = 0 for h 6= 0.
Note that component j is uncorrelated with k at all leads and lags,

but typically correlated simultaneously, i.e. Σε is not usually
diagonal.
Stability of the VAR
O.c.s. that the VAR is stable iff all solutions (roots) ζ of the
(scalar) determinantal polynomial equation
det Θ(L) = 0
fulfill the condition |ζ| > 1. Then, it makes sense to consider the
infinite-order MA representation
Yt = Θ(1)−1 δ + Θ(L)−1 εt = µ + A(L)εt .
The impulse response function

The coefficient matrices of the MA representation of a VAR can be
interpreted as derivatives
∂Yt+h
Ah = ,
∂ε′t
and thus as indicating the response in the components of Y to

‘shocks’ in the components of the error process ε. For this reason,
the k 2 components of the function A(h) are called the
impulse-response function.
A(h) does not really indicate the response to shocks in the
components of past variables Y , due to dynamic feedback. A(h)
also fails to reflect the immediate response of other components in
ε, as Σε is not generally diagonal.
Multivariate cointegration: the concept
Among k I(1) variables, there may be up to k − 1 linearly

independent cointegrating vectors. The cointegrating rank r may
be any value in {0, 1, . . . , k − 1}. Regression methods are an
unreliable device for the estimation of the cointegrating vectors
that may be summarized in a k × r –dimensional cointegrating
matrix of rank r , whose columns are cointegrating vectors.
Multivariate cointegration is best described in the framework of a

vector autoregression. Assume that all components of the VAR are
either I(0) or I(1).
Error-correction representation of VAR

Every VAR of order p
Yt = δ + Θ1 Yt−1 + . . . + Θp Yt−p + εt
can be re-written as a vector error-correction model (VECM)
∆Yt = δ + Γ1 ∆Yt−1 + . . . + Γp−1 ∆Yt−p+1 + ΠYt−1 + εt ,
with matrices Γj and Π being functions of Θ1 , . . . , Θp , in particular
Π = −Ik + Θ1 + . . . + Θp = −Θ(1)
for the long-run matrix Π, which represents all cointegration

features in the system.
The long-run matrix Π

All terms in the model ∆Yt−j , j = 0, . . . , p − 1, εt ,δ are stationary,
so ΠYt−1 must also be stationary. Three cases are of interest:
◮ Π = 0 and rkΠ = 0, the model is a VAR in ∆Y , and there is
no cointegration (k unit roots);
◮ rkΠ = k, any vector β yields β ′ Y stationary, hence Y is
already I(0) and stationary (0 unit roots);
◮ 0 < rkΠ = r < k, we can represent Π = γβ ′ with
k × r –matrices γ and β (k − r unit roots). r is the
cointegrating rank, and all columns of β form a basis of the
cointegrating space. Π and r are unique, though α and β are
not.
No drift in the system

Take expectations on the VECM form (∆Y is stationary):
(I − Γ1 − . . . − Γp )E∆Yt = δ + γE(β ′ Yt−1 ) + Eεt
If there is no linear trend in any Y component, the l.h.s. is 0, and

so is the r.h.s., which implies that δ is proportional to γ or
δ = −γα,
which yields the VECM with restricted intercepts
∆Yt = γ(−α + β ′ Yt−1 ) + Γ1 ∆Yt−1 + . . . + Γp−1 ∆Yt−p+1 + εt .
Example: cointegration in a bivariate VAR

Consider

Yt θ11 θ12 Yt−1 ε1.t
= + ,
Xt θ21 θ22 Xt−1 ε2.t
with
θ11 − 1 θ12
Π = −Θ(1) = .
θ21 θ22 − 1
Cointegration implies that rkΠ = 1 and that the determinant is 0,
i.e. (θ11 − 1)(θ22 − 1) − θ12 θ21 = 0 or

θ11 − 1 θ12
Π= θ12 θ21 .
θ21 θ11 −1
Example: the bivariate VECM
For the bivariate VECM, we obtain

∆Yt 1 ε1.t
= θ21 {(θ 11 − 1)Y t−1 + θ X
12 t−1 } + ,
∆Xt θ11 −1 ε2.t
with the recognizable cointegrating vector (θ11 − 1, θ12 ) = β ′ . One

can check that (θ11 − 1)Yt + θ12 Xt is stationary. Note that
γ = (θ11 − 1, θ21 )′ and β = (1, θ11θ12−1 )′ would also work.
Testing for cointegration in a VAR

For k > 2, regression-based testing for cointegration using
residuals from cointegrating regressions becomes unreliable. The
likelihood-ratio test statistic on the cointegrating rank
H0 : r ≤ r0 vs. HA : r > r0
uses the smallest canonical correlations between variables and their
first differences (eigenvalues of specific matrices)
λ̂1 ≥ λ̂2 ≥ . . . ≥ λ̂k with 0 < λ̂j < 1. The ‘trace’ statistic
k
X
λ(r0 ) = −T log(1 − λ̂j )
j=r0 +1
has a non-standard distribution under H0 . Tabulated significance

points must be used. These differ for the case of a no-drift
restriction.
Recommended steps for the ‘Johansen procedure’
1. Make sure that all component variables are either I(0) or I(1).
The procedure works if some variables are stationary.
2. Determine a lag order p for the VAR, e.g. by AIC.
3. Decide whether to use the no-trend restriction.
4. Determine the cointegrating rank by the trace test sequence,
using a VAR with p lags.
5. Use the estimates for all coefficients from a VECM estimation
that uses the rank r and p − 1 augmenting lags. This step
yields γ̂ and the cointegrating vector(s) β̂, among others.
Why not estimate the cointegrating vector from a regression after
step 4? This is much less efficient.

Advanced Econometrics: Based On The Textbook by Verbeek: A Guide To Modern Econometrics

Uploaded by

Copyright:

Available Formats

You might also like

Advanced Econometrics: Based On The Textbook by Verbeek: A Guide To Modern Econometrics

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Advanced Econometrics: Based On The Textbook by Verbeek: A Guide To Modern Econometrics

Uploaded by

Copyright:

Available Formats

Univariate time series Multivariate time series Panels

Univariate time series

Multivariate time series

Issues with multivariate time series

◮ Regressing integrated variables on other integrated variables

A simple dynamic model

Consider two stationary variables Y and X , with X regarded as

The equilibrium multiplier

The sum of all these multipliers describes the long-run effect

the long-run multiplier or equilibrium multiplier β.

X and Y are stationary, for this reason

∆Yt = φ0 ∆Xt − (1 − θ)(Yt−1 − α − βXt−1 ) + εt ,

an error-correction model: Y adjusts to deviations from

Generalizations to higher lag orders

with lag polynomials of orders p and q and invertible θ(z).

and the long-run multiplier becomes

with the denominator positive because of stability.

The basic experiment of spurious regression

tends to produce significant coefficients and non-zero R 2 . Flanking

Non-spurious regression with integrated variables

Consider two I(1) variables Yt and Xt , with Yt − βXt stationary

yields a coefficient estimate β̂ that is super-consistent for β, i.e.

with a non-standard limit distribution D. Note that errors are I(0)

Cointegration with two variables

The cointegrating relation can be interpreted as a long-run

Testing for cointegration in a simple regression

◮ If the residual unit-root test rejects, there is evidence on

Cointegration and error correction

Engle & Granger have shown that, if X and Y are

θ(L)∆Yt = δ + φ(L)∆Xt−1 − γZt−1 + α(L)εt ,

with Zt = Yt − βXt . If Y deviates positively from the equilibrium

Vector autoregressions: the concept

with Yt , Yt−1 , . . . , Yt−p , εt , δ k–vectors and Θj , j = 1, . . . , p

with Ik denoting the k–dimensional identity matrix. In short, we

Stationarity of multivariate processes

In analogy to the univariate case, the vector variable Yt is said to

The matrix-valued function Γ(h) is the cross-covariance function,

Multivariate white noise

A k–dimensional variable (εt ) is said to be white noise, iff

Note that component j is uncorrelated with k at all leads and lags,

Stability of the VAR

Yt = Θ(1)−1 δ + Θ(L)−1 εt = µ + A(L)εt .

The impulse response function

and thus as indicating the response in the components of Y to

Multivariate cointegration: the concept

Among k I(1) variables, there may be up to k − 1 linearly

Multivariate cointegration is best described in the framework of a

Error-correction representation of VAR

can be re-written as a vector error-correction model (VECM)

∆Yt = δ + Γ1 ∆Yt−1 + . . . + Γp−1 ∆Yt−p+1 + ΠYt−1 + εt ,

with matrices Γj and Π being functions of Θ1 , . . . , Θp , in particular

for the long-run matrix Π, which represents all cointegration

The long-run matrix Π

No drift in the system

(I − Γ1 − . . . − Γp )E∆Yt = δ + γE(β ′ Yt−1 ) + Eεt

If there is no linear trend in any Y component, the l.h.s. is 0, and

which yields the VECM with restricted intercepts