Applied Econometrics – 4th Edition

Solutions to End of Chapter Exercises

Dr Dimitrios Asteriou
Chapter 15: VAR Models and Causality

Exercise 15.1
(a) In order to calculate the first logarithmic differences the commands are:

ls d_dm=log(dm)log(dm(-1))

ls d_bp=log(bp)log(bp(-1))

ls d_cd=log(cd)log(cd(-1))

ls d_dy=log(dy)log(dy(-1))

ls d_sf=log(sf)log(sf(-1))

To estimate a VAR model, we go to Quick/Estimate VAR. The following window appears:

In the endogenous variables box we type the name of the differenced variables (see below). Note also that
the default is a Standard VAR (we do not change that for the moment) and 1 to 2 lags (for a VAR(2). If we
want to estimate a higher lag we increase the number of lags (note: the results here are for the first 1500
observations. If one uses the full range of observations the obtained results might be slightly different).
After typing the variable names, we click OK and we get the results shown below:
From a quick look at the t-stats we see that exchange returns do not affect each other (most t-stats are non-
significant) which suggests that the exchange rate market is efficient (see Efficient Market Hypothesis). The
only cross effect that is observed is from D_DY(-1) to D_CD (from the lagged yen to the Canadian Dollar).

To get the Granger Causality results, we go Quick/Group Statistics/Granger Causality test. Then we again
type the variable names and we chose the lag order (the default is 2). The results are given below:
We observe that all F-stats are statistically insignificant for the 95% significance level (all p-values are quite
high). Therefore, there is no causal relationship from exchange rate returns from one country to another
(again verifying the efficient market hypothesis).

Exercise 15.2

Exercise 15.3
Those two exercises are very similar to Exercise 15.1 above.
Exercise 15.4
Before estimating the VAR models and running the causality tests, we present a time plot of all series.

We see that the variable growth (GDP growth) seems stationary. However, the rest of series (although they
are ratios to GDP) are trended, so they might not be stationary. Inflation and Interest Rates exhibit trends as
well. We leave the stationarity tests as an exercise for Chapter 16 later. Note however, that if we want to
make these series stationary, simple first-differences should be taken (and not log-differences) since these
variables are all percentages.

The results of the VAR(1) model are shown below (note: in order to obtain results for VAR of order 1, we
need to change the lag length from the default (1 2) to (1 1).

If we concentrate our analysis to the GDP growth equation, we see that lagged inflation and lagged taxes are
statistically significant and affect GDP negatively. We leave the rest of the discussion for the reader.
(b) Next, we estimate the VAR(2) model. A picture showing some of the results is shown below.
 (c) The impulse response functions are shown below (they are obtained by clicking the impulse button):

We see what is the effect from one variable to another with a significance level band above and below and
how this evolves in the next 10 years.
 (d) The Granger Causality tests (for 1 lag) follow (we show only one part of the pairwise tests):

We will discuss some of the results to see the three different cases:

First, we see that GDP growth granger causes debt (F-stat 14.76 rejects the null of no causality), while the
reverse is not true (debt does not Granger Cause growth). This is unidirectional causality from GDP growth to
Debt.

Also, there is clear evidence of bi-directional causality from Inflation to Growth and vice-versa (both F-stats
reject the null of no causality).

Finally, there is no causality relationship between TAX and DEBT (both F-stats are very low and hence fail to
reject the null of no causality). We leave the discussion of the other tests to the reader.