TIME SERIES

QUESTIONS AND ANSWERS

1. What is meant by weak stationarity?
Weak stationary means that the mean and variance are constant overtime and if the value
of the covariance between two time periods depends only on the distance or lag between
the two period and not the actual time at which the covariance is computed.
2. What is meant by an integrated time series?
Integrated time series means that if a time series has to be differenced d times before it
becomes stationary, it is integrated of odder d, denoted by I (d).
3. What is the meaning of unit root?
The term unit root means that a given time series is nonstationary.
Let us write the Random Walk Model as: Yt = ρYt−1 + ut where −1 ≤ ρ ≤ 1
If ρ = 1, equation becomes a RWM (without drift). If ρ is in fact 1, we face what is
known as the unit root problem, that is, a situation of non-stationarity. The name unit root
is due to the fact that ρ = 1.
4. If a time series is I(3), how many times would you have to difference it to make it
stationary?
It has to be differenced three times to make it stationary.
5. What are Dickey–Fuller (DF) and augmented DF tests?
The DF test is a statistical test that can be used to determine if a time series is stationary.
The ADF is similar to DF except that it takes into account the possible correlation in the
error terms.
6. What are Engle–Granger (EG) and augmented EG tests?
The EG and AEG tests are statistical procedures that can be used to to determine if two
time series are cointegrated.
7. What is the meaning of cointegration?
Two variables are said to be cointegrated if there is a stable long-run relationship between
them, even though individually each variable is nonstationary. In that case the regression
of one variable on the other is not spurious.
8. What is the difference, if any, between tests of unit roots and tests of cointegration?
Tests of unit roots are performed on individual time series. Cointegration deals with the
relationship among a group of variables, where (unconditionally) each has a unit root.
9. What is spurious regression?
Spurious regression refers to a situation in time series analysis where two unrelated time
series variables exhibit a high degree of apparent correlation or association, even though
there is no genuine causal relationship between them.
According to Granger and Newbold, an R2 > d is a good rule of thumb to suspect that the
estimated regression is spurious.
Example; Suppose you have two time series data: the number of storks observed in a
given region and the birth rate in that same region over several years. If you were to run a
regression analysis on these two variables, you might find a statistically significant
relationship between them, suggesting that more storks lead to higher birth rates or vice
versa.
However, this correlation is spurious because there is no causal relationship between the
number of storks and human birth rates. Instead, both variables are likely influenced by a
third factor, such as population growth or urbanization.
10. What is the difference between a deterministic trend and a stochastic trend?
Most economic time series exhibit trends. If such trends are perfectly predictable, we call
them deterministic. If that is not case, we call them stochastic. A nonstationary time
series generally exhibits a stochastic trend.
11. What is meant by a trend-stationary process (TSP) and a difference stationary process
(DSP)?
If a time series exhibits a deterministic trend, the residuals from the regression of such a
time series on the trend variable represents what is called a trend-stationary process. If a
time series is nonstationary but becomes stationary after taking its first (or higher) order
differences, we call such a time series a difference-stationary process.
12. What is a random walk (model)?
A random walk is an example of a nonstationary process. If a variable follows a random
walk, it means its value today is equal to its value in the previous time period plus a
random shock (error term). In such situations, we may not be able to forecast the course
of such a variable over time. Stock prices or exchange rates are typical examples of the
random walk phenomenon.
13. “For a random walk stochastic process, the variance is infinite.” Do you agree? Why?
This is true. (Refer to the notes and prove)
14. What is the error correction mechanism (ECM)? What is its relation with cointegration?
The error correction mechanism (ECM) first used by Sargan and later popularized by
Engle and Granger corrects for disequilibrium. An important theorem, known as the
Granger representation theorem, states that if two variables Y and X are cointegrated, the
relationship between the two can be expressed as ECM.
Cointegration implies a long term, or equilibrium, relationship between two (or more
variables). In the short run, however, there may be disequilibrium between the two. The
ECM brings the two variables back to long term equilibrium.
15. From the U.K. private sector housing starts (X) for the period 1948 to 1984, Terence
Mills obtained the following regression results.

The 5 percent critical τ value is −2.95 and the 10 percent critical τ value is −2.60.
 i. On the basis of these results, is the housing starts time series stationary or
nonstationary? Alternatively, is there a unit root in this time series? How do you
know?

Solution

Since absolute tau calculated is less than the absolute tau critical at any level of
significance. It seems housing starts time series is not stationary. Therefore, there is a
unit root.

ii. If you were to use the usual t test, is the observed t value statistically significant?
On this basis, would you have concluded that this time series is stationary?

Solution

An absolute t value of as much as 2.35 or greater would be significant at the 5%. But
because of the unit root situation, the absolute t value is 2.95 and not 2.35. This show
that you should be careful in using t statistic indiscriminately.

iii. Now consider the following regression results:

where ∆2 is the second difference operator, that is, the first difference of the first
difference. The estimated τ value is now statistically significant. What can you
say now about the stationarity of the time series in question?
Solution
Since the absolute tau calculated of ∆t-1 is greater (5.89) is greater than absolute
tau critical at 5% and 10% (2.95 and 2.60). It seems the time series is stationary.
16. From the data for the period 1971 to 1988 for CANADA, the following regression result
were obtained

where M1 = M1 money supply, GDP = gross domestic product, both measured in billions
of Canadian dollars, ln is natural log, and u represent the estimated residuals from
regression 1.
a. Interpret regressions 1 and 2.
Solution
Regression 1 show that the elasticity of M1 with respect to GDP is about 1.5975.
The t-calculated is 25.8865 is very high than the t-critical at different significance
level which show that coefficient of GDP is statistically significant.
The R2 is about 0.9463 which means that about 94.63% variation of M1 is
explained by variation of GDP.

Regression 2 show that the elasticity of M1 with respect to GDP is about 0.5833.
The t-calculated is 1.8958 is less than the t-critical at 5% that is 1.96 which show
that coefficient of GDP is not statistically significant.
The R2 is about 0.0885 which means that about 8.85% variation of M1 is
explained by variation of GDP.
 b. Do you suspect that regression 1 is spurious? Why?
Solution
Yes, Regression 1 is spurious regression because R2 (0.9463) value is greater than
Durbin Watson test (d) (0.3254).
c. Is regression 2 spurious? How do you know?
Solution
No, Regression 2 is not spurious because R2 (0.0885) value is less than Durbin
Watson test (d) (1.7399).
d. From the results of regression 3, would you change your conclusion in b? And
why?
Solution
From Regression 3 it seems that the two variable are cointegrated, for the 5% tau
critical value that is -1.9495 and the calculated tau value is -2.2521 which is
greater than critical value.
However, at 1% the tau calculated is less than critical which show that the two
variable are not cointegrated.
e. Now consider the following regression:

What does this regression tell you? Does this help you decide if regression 1 is spurious
or not?
Solution
Equation above gives the short-run relationship between the logs of money and GDP. The
equation given here takes into account the error correction mechanism (ECM), which
tries to restore the equilibrium in case the two variables veer from their long-run path.
However, the error term in this regression is not statistically significant at the 5% level.
It is hard to tell whether the regression results presented in (1) are spurious or not.
17. Check whether Yt = B0 + B1t + ut is a stationary or not
Solution
For stationary means that mean and variance should be constant
E(Yt) = E(B0 + B1t + ut)
Recall, E(ut) = 0
So,
E(Yt) = B0 + B1t
Therefore, the mean is not constant because it depends on the value of t.
Var(Yt) = Var (B0 + B1t + ut)
Recall, Variance of constant is 0.
So, Var (B0 + B1t) = 0
Var (Yt) = σ2
The variance is constant.
But because the mean is not constant. The time series is not stationary.
18. Write short notes on the following (Use
example/illustration where possible)
a Univariate times series and multivariate time series
Solution

Univariate Times Series analyses the behavior of a single variable based on its own
history

e.g. 𝑌𝑡 = 𝐶 + 𝜑1𝑌𝑡−1 + 𝜑2𝑌𝑡−2 + 𝑡

On the other hand, Multivariate Time Series deals with the relationship among group of
variables over time

e.g. 𝐶𝑡 = 𝐶 + 𝜑1𝑌𝑡 + 𝜑2𝑊𝑡 + 𝑡

 b. Second Order Stationary

Solution

A stochastic process, 𝑌𝑡is said to be second order stationary if it satisfies the following
properties:
-mean is time invariant (constant);

-variance is time invariant (constant); and

-autocovariances do not depend on time but on time lag

Also known as weakly stationary, or covariance stationary

Mathematically, it can be represented as:
𝐸(𝑌𝑡) = 𝜇, ∀𝑡

𝑉𝑎𝑟(𝑌𝑡) = 𝐸(𝑌𝑡 − 𝜇)2 = 𝜎2, ∀𝑡

𝐸[(𝑌𝑡 − 𝜇)(𝑌𝑡+𝑘 − 𝜇)] = 𝛾𝑘, for 𝑘 ≠ 0 i.e. does not depend on 𝑡 but on 𝑘 where: 𝑘
= the length of time separating the observations
𝑡 = the date of observation

c) Most macroeconomic time series are difference stationary

Solution
This means that macroeconomic time series variables can be made stationary through
differencing

d) For stationary time series, the autocorrelogram dies off gradually, whereas for
nonstationary time series it tapers off quickly (True/False, explain)
Solution
False
For stationary time series, the autocorrelogram tapers off quickly, whereas for
nonstationary time series it dies off gradually, OR
If the autocorrelations at various lags hover around zero (decrease of autocorrelogram is
fast) → Stationary Time Series
 If the autocorrelation coefficient starts at a very high value at lag 1 and declines very
slowly (decrease of autocorrelogram is gradual) →Non-stationary Time Series.

e) Show that a random walk model with drift is a non-stationary process

Solution
A random walk model with drift is given by 𝑌𝑡 = 𝛿 + 𝑌𝑡−1 + 𝜇𝑡 where 𝜇𝑡~𝐼𝐼𝐷(0, 𝜎2) and 𝛿
is a drift parameter From above:
𝑌1 = 𝛿 + 𝑌0 + 𝜇1
𝑌2 = 𝛿 + 𝑌1 + 𝜇2 = 2𝛿 + 𝑌0 + 𝜇1 + 𝜇2
𝑌3 = 𝑌2 + 𝜇3 = 3𝛿 + 𝑌0 + 𝜇1 + 𝜇2 + 𝜇3
Generally,

𝑌𝑡 = 𝑌0 + 𝑡𝛿 + ∑ 𝜇𝑡

Thus:

𝐸(𝑌𝑡) = 𝑌0 + 𝑡𝛿

𝑉𝑎𝑟(𝑌𝑡) = 𝑡𝜎2

Since both mean 𝐸(𝑌𝑡)and 𝑉𝑎𝑟(𝑌𝑡) are time variant then random walk model with drift is
a non-stationary process.

19. i. Fill the following table if the value of the random process𝑌 in 2010 is 3

𝑡 𝑌𝑡 𝑌𝑡−1 ∆𝑌𝑡
2011 5
2012 9
2013 12
2014 17
2015 19
2016 18
2017 15
 Solution

𝑡 𝑌𝑡 𝑌𝑡−1 ∆𝑌𝑡
2011 5 3 2
2012 9 5 4
2013 12 9 3
2014 17 12 5
2015 19 17 2
2016 18 19 -1
2017 15 18 -3

ii. From the Tanzania M1 money supply for the period 1978 to 2014, the following
regression results were obtained:

𝑡(= 𝜏) = (0.7919)(4.4227) (−3.0046)

𝑅2 = 0.0670𝑑 = 0.7172

Note: The 1, 5, and 10 percent critical 𝜏 values are −3.9811, −3.4210, and −3.1329 respectively

Comment on the stationarity of the above regression

Solution

Since the computed absolute𝑡 (= 𝜏) value of 3.0046 is smaller than any of these critical values in
absolute terms, the conclusion is that the M1 time series is nonstationary; that is, it contains a
unit root or it is 𝐼(1)
 20. Catherine is a financial analyst who works at ABC Company. She wants to analyze her
financial statements. However, she finds herself in dilemma on what data she can use. As
an econometrician what would you advise Catherine in these scenarios? Give
justifications to your answer.

a. Comparing financial statements of ABC company with XYZ company in

2021.

Solution

Cross sectional data

In econometrics, cross section data refers to data that is collected from a sample of individuals,
firms, or other economic units at a single point in time. This type of data is in contrast to time
series data, which is collected over multiple time periods. Cross section data is used to study the
relationships between different economic variables, such as income and education level, or
consumer spending and age. Econometric techniques such as regression analysis are commonly
used to analyze cross section data and make inferences about the population from which the
sample was drawn. It is commonly used in fields such as labor economics, consumer economics,
and micro-econometrics.

b. Analyzing the trend and performance of XYZ company since its

inauguration.

Solution

Time series data

Time series data refers to data that is collected and recorded at regular intervals over time. This
could include things like stock prices, weather data, or sensor readings. The intervals at which
the data is collected can be fixed (e.g. every minute, every hour, every day) or irregular. Time
series data is often analyzed to identify trends, patterns, and forecast future values.
 21. Explain the main components of time series data. Which of these would be most
prevalent in data relating to inflation?

Solution

For data relating to inflation, the trend component would likely be the most prevalent, as it
would indicate the overall direction of inflation over time. This would be important for
understanding whether inflation is increasing or decreasing and at what rate.

22. The least-squares trend line for an annual time series containing 40 observations (from
1961 to 2000) on real net sales (in billions of constant 1995 dollars) is: Y = 1.2 + 0.5Xi

a. Interpret the Y intercept, b0, in this linear trend model

b. Interpret the slope, b1, in this linear trend model

Solution

a. The Y intercept, b0, in this linear trend model represents the predicted value of Y when X
= 0. In this case, the Y intercept is 1.2, which means that the predicted value of real net sales (in
billions of constant 1995 dollars) when X = 0 is 1.2 billion dollars.

b. The slope, b1, in this linear trend model represents the change in Y for every unit change
in X. In this case, the slope is 0.5, which means that for every unit increase in X (which
represents the year in this case), the predicted value of real net sales (in billions of constant
1995 dollars) is expected to increase by 0.5 billion dollars.
23. What is time series?

Solution

Time series data refers to data that is collected and recorded at regular intervals over time. This
could include things like stock prices, weather data, or sensor readings. The intervals at which
the data is collected can be fixed (e.g. every minute, every hour, every day) or irregular. Time
series data is often analyzed to identify trends, patterns, and forecast future values.
 24. The trend line equation of a time series with middle year 2007 is given by
Y = 95 + 3. 9t.
Estimate a trend value for the year 2015. Also eliminate the trend
assuming the actual value to be 125. 2

Solution

To estimate a trend value for the year 2015, we can substitute t = 2015 - 2007 = 8 into the trend
equation. This gives us Y = 95 + 3.9(8) = 126.2.

To eliminate the trend assuming the actual value to be 125.2, we can subtract the trend value
(126.2) from the actual value (125.2) to get the residual or detrended value, which is -1.
25. Mention the components of a time series.

Solution

The components of a time series include:

i. Trend:

The overall direction of the data over time, whether it is increasing, decreasing, or
staying the same.

ii. Seasonality:

Repeating patterns or cycles within the data that occur at regular intervals, such as
daily, weekly, or yearly.

iii. Cyclical:

Fluctuations in the data that occur at irregular intervals and may be related to economic
or other external factors.

iv. Irregularity:
 Random or unpredictable fluctuations in the data that cannot be explained by trend,
seasonality, or cyclical factors.

26. From the U.K. private sector housing starts (X) for the period 1948 to 1984, Terence
Mills obtained the following regression results:

Xt = 31.03 − 0.188Xt−1
se = (12.50) (0.080)
(t =) τ (−2.35)
Note: The 5 percent critical τ value is −2.95 and the 10 percent critical τ value is −2.60.

a. On the basis of these results, is the housing starts time series stationary or nonstationary?
Alternatively, is there a unit root in this time series? How do you know?

Solution

Since |τ| is less than the critical |τ| value, it seems that the housing start time series is
nonstationary. Therefore, there is a unit Root in this time series.
b. If you were to use the usual t test, is the observed t value statistically significant? On this
basis, would you have concluded that this time series is stationary?
Solution

Ordinarily, an absolute t value of as much as 2.35 or greater would be significant at the 5%

level. But because this unit root situation, the true |τ| value here is 2.95. This show why one has
to be careful in using the t statistic indiscriminately.
c. Now consider the following regression results:
2
Xt = 4.76 − 1.39 Xt−1 + 0.313 2Xt−1
se = (5.06) (0.236) (0.163)
(t = )τ (−5.89) where 2
is the second difference operator, that is, the first
difference of the first difference.
The estimated τ value is now statistically significant. What can you say now about the
stationarity of the time series in question?
Solution

Since the |τ| of Xt is much greater than the corresponding critical value, we conclude that there
is no second unit root in the housing start time series.