Lecture sheet on econometrics: Chapter seven

Time Series Econometrics II

1. Spurious regression
In regressing a time series variable on another time series variable, one
often obtains a very high R 2 although there is no meaningful
relationship between the two. This situation exemplifies the problem of
spurious regression. This problem arises because if both the time series
involved exhibit strong trends (sustained upward or downward
movements), the high R 2 observed is due to the presence of the trend,
not to a true relationship between the two. It therefore is very
important to find out if the relationship between economic variables is
true or spurious. We will see in this section how spurious regression can
arise if time series are not stationary.

Granger and Newbold (1974) coined the phrase “spurious regressions”

to describe regression results, involving economic time series, that “look
good”, in the sense of have high R 2 values and significant t-statistics,
but which, in fact, have no real meaning. This outcome can occur when a
regression model is specified, say

Yt  1   2 X t  ut (i)

involving economic time series Yt and X t that are trended or non-

stationary random processes. Equation (i) is a regression model with a
random regressor X t .

To illustrate the problem of spurious regression Granger and Newbold

carried out a Monte Carlo experiment in which the nonstationary series
Yt and X t were generated as independent random walks. In their
Monte Carlo experiment they created samples of T  50 observations
on Yt and X t , which were, to repeat, independent random walks.
When they estimated the regression model (i), however, they found that
the usual t -test of the null hypothesis H 0 :  2  0 was rejected (wrongly)
75% of the time when testing at the   0.05 level of significance.
Hence a “significant” relationship was found, where none existed, in
three-quarters of the cases. Granger and Newbold concluded that when
regression equations like equation (i) are specified between the levels of
economic time series that are “like” random walks, (i) such regression
equations frequently have high R 2 values, and (ii) at the same time
they have low Durbin-Watson statistics indicating highly autocorrelated
disturbance terms. Granger and Newbold contended that in situations
like this, the usual t -tests of statistical significance can be very
misleading because they reject the null hypothesis of “no relationship”
much too frequently, and, thus, accept as significant relationships that
are spurious far too often.

Granger and Newbold suggested that when a least squares regression

leads to a high R 2 but low Durbin-Watson statistic, then the
relationship should be estimated in first differences of the variables
rather than the levels, that is, estimate

Yt  1   2 X t  vt (ii)

If the errors in equation (i) are uncorrelated and ut ~( 0 ,  2 ) then

vt  ut  ut 1 will be serially correlated [as MA1 ], but the least squares
estimator of  2 in equation (ii) is still consistent, even though it is
biased and is inefficient related to the generalized least squares
estimator. In this sense, it is safer o estimate (ii) by least squares than
equation (i). The Monte Carlo results of Granger and Newbold indicate
that the estimation of equation (ii) does not lead to over acceptance of
spurious relationships as significant ones.

The findings of Granger and Newbold have subsequently been

theoretically explained. For regressions between integrated time series
(that is, time series that must be differenced once or more to be
stationary), distributions of conventional test statistics (e.g., t , F ) do
not have distributions anything like t -and F - distributions that we
expect to hold when a null hypothesis is true. Consequently, critical
values normally used are inappropriate. Furthermore, the least squares
estimators of the intercept and slope are not consistent and the
Durbin-Watson statistic converges to zero. In a nutshell, the usual
properties of least squares estimators in equation (i) do not hold when
Yt and Xt are integrated economic time series that require
differencing to achieve stationarity.

2. Cointegration
A remarkable link between nonstationary processes and the concept of
long-run equilibrium was introduced by Granger (1981). The link is the
concept of cointegration. Although the concept is a very general one, for
this discussion we will consider its simplest form.
If an economic time series Yt follows a random walk, its first
differences form a stationary series. In this case Yt is said to be an
integrated process of order 1 and denoted I 1 . On the other hand, if Yt
is stationary, then it is integrated of order zero and denoted I 0  .
Granger and Newbold warned of regressing one I 1 variable on
another I 1 variable and called these regressions “spurious”, since the
least squares estimator, it turns out, breaks down in this case. Granger,
however, identified a situation when the regression of an I 1 process
on an I 1 process was not spurious. In fact in a situation where the
variables are cointegrated, the least squares estimator works better, in
that it converges to the true parameter value faster than usual.

If two time series Yt and X t are I 1 then, in general, the linear
combination

Yt     X t  ut (i)

is also I 1 . However, it is possible that ut is stationary, or I 0  . In

order for this to happen the “trends” in Yt and X t must cancel out
when ut  Yt    X t is formed. In this case, Yt and X t are said to be
cointegrated, and  is called the cointegrating parameter. Thus a pair
of series Yt , X t are defined as cointegrated if they are each I 1 but
there exists a linear combination of them, ut  Yt    X t , that is I 0  .

The concept of cointegration relates to, or in a sense mimics, the

concept of long-run equilibrium in the following way. Suppose a long-
run equilibrium relationship was defined by Yt    X t , or
Yt     X t  0 . In that case, ut in equation (i) would represent how far
Yt and X t were away from equilibrium and could be called the
“equilibrium error”. If Yt and X t are cointegrated and the error ut is
stationary with mean 0 , then

Yt     X t  ut (ii)

Since ut ~( 0 ,  2 ) is stationary, the variables Yt and X t obey a stable,

long-run relationship. In this case, where Yt and X t are cointegrated,
least squares estimation of equation (ii) provides in large samples an
excellent (super consistent) estimator of  , which describes the long-
run, steady-state equilibrium relationship between Yt and X t .

Once we have an economic model involving Yt and X t , an important

question is: How can we tell if two variables are cointegrated? One
answer is derived from equation (ii). If Yt and X t are cointegrated,
then u t ~ I 0  and is stationary. If Yt and X t are not cointegrated,
then u t ~ I 1 is not stationary. Thus we can estimate equation (ii),
which is called the cointegrating regression, by least squares and test
whether or not the residuals ût are stationary using a modified
Dickey-Fuller unit root test. The test must me modified, since it is based
on calculated least squares residuals.

Let ût be the least squares residuals from the cointegrating regression
in equation (ii). Form the first-order autoregressive model

uˆt  uˆt 1  vt (iii)

In this AR1 model ût is stationary if   1 . But if   1 , then the

errors are nonstationary. To carry out a test of the null
hypothesis H 0 :   1 , subtract uˆt 1 from both sides of equation (iii) to
form

uˆt  uˆt  uˆt 1    1uˆt 1  vt

  uˆt 1  vt

The null hypothesis is H 0 :   1 or    0 . The null hypothesis is

rejected, on the basis of a one-tailed t -test, if t  tc  , where the critical
values tc  are given in Engle and Yoo (1987, p. 157, Table 2):
“Forecasting and Testing in Co-integrated Systems,” Journal of
Eonometrics, 35.

3. Error correction model (ECM)

In regression analysis an ECM combines long-run and short-run
interaction amongst a group of variables. It is closely related to
cointegration amongst the same group of variables and implies that
differences (the short-run effect) and levels (the long-run effect) of the
variables may be specified in the same regression model without
introducing a spurious regression problem.

If Yt and X t are both of the same order of integration d  , and

assuming that d  1 , then an equation of the form

Yt  1X t   2 Yt   X t   vt

Is a valid equation provided Yt and X t are cointegrated. Thus Yt ,

X t , Yt   X t , and vt are all integrated of order zero.

Remarks:
1. Regression of one time series variable on one or more time series
variables often can give nonsensical or spurious results. This
phenomenon is known as spurious regression. Spurious regressions
describe exercises in which one nonstationary variable is regressed on
another nonstationary variable(s).

2. One way to guard against spurious regression is to find out if the time
series are cointegrated.

3. Cointegration means that despite being individually nonstationary, a

linear combination of two or more time series can be stationary. Various
tests like EG, AEG, and CRDW tests can be used to find out if two or
more time series are cointegrated.

4. Where a group of variables linked in a regression model are

cointegrated then the disturbance term is known as the equilibrium
error.

5. Cointegration of two (or more) time series suggests that there is a

long-run, or equilibrium, relationship between them.

6. The error correction mechanism (ECM) developed by Engle and

Granger is a means of reconciling the short-run behavior of an economic
variable with its long-run behavior.
 Chapter eight
Time Series Econometrics III: Forecasting with ARIMA and VAR models

 AR , MA , ARMA , ARIMA models, The Box-Jenkins methodology.

 SARIMA, ARCH, GARCH, EGARCH, TARCH models.

 VAR model, Estimation of VAR model, VEC model.

Chapter nine
Time Series Econometrics IV: Nonlinear least squares

 nonlinear models.

 principles of nonlinear least squares estimation.

 properties of the nonlinear least squares estimator.