Solitions To Problems in TE-II

Addis Ababa University
College of Business and Economics

Department of Economics
Econ 654: Research Methods & Applied Econometrics
1.Tutorial Exercise II
Fantu Guta Chemrie (PhD)

F. Guta (CoBE) CoBE
Econ 654 September, 2017 1 / 40
1). Consider the following very simple relationship between
aggregate savings St and aggregate income Yt .
St = α + βYt + et
For some country this relationship is estimated by OLS over
the years 1946-1995 (T=50). The results are given in Table 1
below:
Table 1: Aggregate savings explained from aggregate income: OLS Results
Variable Coefficient Standard error t-ratio
constant 38.900 4.570 8.51
income 0.098 0.009 10.77
T=50 s=22.57 R2=0.93 DW=0.70
F. Guta (CoBE) Econ 654 September, 2017 2 / 40

Assume, for the moment, that the series St and Yt are
stationary.
a). How would you interpret the coe¢ cient estimate of 0.098 for
the income variable?
b). Explain why the results indicate that there may be a problem
of positive autocorrelation. Can you give arguments why, in
economic models, positive autocorrelation is more likely than
negative autocorrelation?

c). What are the e¤ects of autocorrelation on the properties of
the OLS estimator? Think about unbiasedness, consistency
and the BLUE property.
d). Describe two di¤erent approaches to handle the

autocorrelation problem in the above case. Which one would
you prefer?
From now on, assume that St and Yt are nonstationary I(1)
series.
e). Are there indications that the relationship between the two
variables is ‘spurious’?
f). Explain what we mean by ‘spurious regressions’.

g). Are there indications that there is a cointegrating relationship
between St and Yt ?
h). Explain what we mean by a ‘cointegrating relationship’.

i). Describe two di¤erent tests that can be used to test the null
hypothesis that St and Yt are not cointegrated.
j). How do you interpret the coe¢ cient estimate of 0.098 under
the hypothesis that St and Yt are cointegrated?
k). Are there reasons to correct for autocorrelation in the error
term when we estimate a cointegrating regression?
l). Explain intuitively why the estimator for a cointegrating

parameter is super consistent.
m). Assuming that St and Yt are cointegrated, describe what we

mean by an error-correction mechanism. Give an example.
What do we learn from it?
n). How can we consistently estimate an error-correction model?

Solution to Problem 1:
a). How would you interpret the coe¢ cient estimate of 0.098 for
the income variable?
The coe¢ cient estimate of 0.098 for the income variable is
interpreted as the saving rate, i.e., a 1% increase in income
results in a 0.098% increase in savings.
b). Explain why the results indicate that there may be a problem
of positive autocorrelation. Can you give arguments why, in
economic models, positive autocorrelation is more likely than

negative autocorrelation?
As can be seen from Table 1 above the value of DW-statistic
is smaller than two and this is an indication of a positive
autocorrelation. In economic models, positive autocorrelation
is more likely than negative autocorrelation because most of
the time the relationship between economic models is positive
than being negative. In this particular model, when income
increases, we anticipate an increase in savings.
c). What are the e¤ects of autocorrelation on the properties of

the OLS estimator? Think about unbiasedness, consistency
and the BLUE property.
In the presence of autocorrelation, OLS estimators remain
unbiased. However, OLS estimators are less e¢ cient, will no
longer be consistent and the standard errors are estimated in
the wrong way. Therefore, in the presence of autocorrelation,
OLS estimators will no longer be BLUE.
d). Describe two di¤erent approaches to handle the

autocorrelation problem in the above case. Which one would
you prefer?
In many cases the …nding of autocorrelation is an indication
that the model is misspeci…ed. If this is the case, the natural
route is to change model speci…cation. Typically, three
(interrelated) types of misspeci…cation may lead to a …nding of
autocorrelation in your OLS residuals: dynamic
misspeci…cation, omitted variables and functional form
misspeci…cation.
The alternative approach to handle the autocorrelation

problem is to transform the variables in such a way
that residuals from our regression is white noise.
The best approach to handle the problem of

autocorrelation is to change the model speci…cation.
e). Are there indications that the relationship between

the two variables is ‘spurious’?
Yes. The fact that DW < R 2 is a simple rule of

thumb that indicates the relationship between the
two variables is ‘spurious’.
f). Explain what we mean by ‘spurious regressions’.
Consider two variables, Yt and Xt , generated by

two independent random walks, and suppose a
researcher, unfamiliar with these processes, may
want to estimate a regression model explaining Yt
from Xt and a constant,
Yt = α + βXt + et (f.1)
The results from this regression are likely to be

characterized by a fairly high R 2 statistic, highly
autocorrelated residuals and a signi…cant value for
β. This phenomenon is known as the problem of
nonsense or spurious regressions.
Alternatively, when two nonstationary series does

not have the same stochastic trend in common,
regressing one of the variables on the other variable
results in a spurious regression.
g). Are there indications that there is a cointegrating

relationship between St and Yt ?
There are no indications that there is a
cointegrating relationship between St and Yt . A
fairly high R 2 statistic (0.93)), highly
autocorrelated residuals (DW = 0.7) and a
signi…cant value for β (t ratio = 10.77) are all
indications of a spurious regression.
h). Explain what we mean by a ‘cointegrating

relationship’.
When two nonstationary series have the same

stochastic trend in common, there exists a linear
relationship between them and the resulting
regression is known as a ‘cointegrating relationship’.
i). Describe two di¤erent tests that can be used to test

the null hypothesis that St and Yt are not
cointegrated.
Suppose we estimate the ‘cointegrating regression’
St = α + βYt + et (i.1)
If St and Yt are cointegrated the error term in (i.1)
is I (0). If not, et will be I (1). Hence, one can test
for the presence of a cointegrating relationship by
testing for a unit root in the OLS residuals b
et from
(i.1). It seems that this can be done by using the
Dickey–Fuller test. For example, one can run the
regression,
∆b
e t = γ 0 + γ 1b
et 1 + υt
and test whether γ1 = 0 (a unit root). However,

the appropriate critical values are more negative
than those for the standard Dickey–Fuller tests.
An alternative test for cointegration is based on the

usual DW-statistic from (i.1). Note that the
presence of a unit root in b
et asymptotically
corresponds with a zero value for the DW-statistic.
Thus under the null hypothesis of a unit root, the
appropriate test is whether DW is signi…cantly larger
than zero.
Unfortunately, critical values for this test, commonly
referred to as the Cointegrating Regression
Durbin–Watson test or CRDW test , depend upon
the process that generated the data.
j). How do you interpret the coe¢ cient estimate of

0.098 under the hypothesis that St and Yt are
cointegrated?
Under the hypothesis that St and Yt are

cointegrated, the coe¢ cient estimate of 0.098 is
interpreted as the cointegrating parameter, or, more
0
generally, (1, 0.098) being called the
cointegrating vector.
k). Are there reasons to correct for autocorrelation in

the error term when we estimate a cointegrating
regression?
There are no reasons to correct for autocorrelation

in the error term when we estimate a cointegrating
regression because what matters is the residuals
from a cointegrating regression being stationary.
l). Explain intuitively why the estimator for a

cointegrating parameter is super consistent.
For cointegrating regression, the relevant asymptotic

theory is nonstandard, it can be shown that one can
consistently estimate β from an OLS regression of
Yt on Xt as in (f .1). In fact, in this case, the OLS
estimator b is said to be super consistent for β,
because it converges to β at a much faster rate
than with conventional asymptotics.
p
In the standard case, we have that T (b β) is
asymptotically normal and we say that b is
p
T -consistent for β. In the cointegration case,
p
T (b β) is degenerate, which means converges
to zero. Instead, the appropriate asymptotic
distribution is the one of T (b β). Consequently,
conventional inference procedures do not apply.
The intuition behind the super consistency result is
as follows. Suppose the estimated regression model is
α+b
Yt = b βXt + b
et (l.1)
For the true value of β, Yt βXt is I (0). Clearly, for

b
β 6= β, the OLS residual b
et will be nonstationary and hence
will have a very large variance in any …nite sample. For
b
β = β, however, the estimated variance of b
et will be much
α and b
smaller. Since ordinary least squares chooses b β to
minimize the sample variance of b
et , it is extremely good in
…nding an estimate close to β.
m). Assuming that St and Yt are cointegrated, describe
what we mean by an error-correction mechanism.
Give an example. What do we learn from it?
The presence of a CR implies that there exists an

ECM that describes the short-run dynamics
consistently with the long-run relationship. A simple
example of an error correction model is:
∆St = δ + θ 1 ∆Yt γ (St 1 α βYt ) + et

We learn from an error correction model how the
short-run movements adjust consistently with the
equilibrium error.
n). How can we consistently estimate an

error-correction model?
An error-correction model can consistently be

estimated by OLS.

2). In the …les INCOME we …nd quarterly data on UK
nominal consumption and income, for 1971 : 1 to
1985 : 2 (T = 58).
a). Test for a unit root in the consumption series using
several augmented Dickey–Fuller tests.
b). Perform a regression by OLS explaining
consumption from income. Test for cointegration
using two di¤erent tests.
c). Perform a regression by OLS explaining income
from consumption.
Test for cointegration.
d). Compare the estimation results and R 2 ’s from the

last two regressions.
e). Determine the error-correction term from one of the
two regressions and estimate an error-correction
model for the change in consumption. Test whether
the adjustment coe¢ cient is zero.
f). Repeat the last question for the change in income.
What do you conclude?
Solution to Problem 2:
a). Test for a unit root in the consumption series using

several augmented Dickey–Fuller tests.
Test for a unit root in the consumption series.

Results in the above table indicate that there is a
unit root in the consumption series in a
Dickey-Fuller regression with a constant.
unit root in consumption series in a Dickey-Fuller
regression with a constant and trend.

unit root in consumption series in augmented
Dickey-Fuller regression with a constant, and two
lags of consumption.
Dickey-Fuller regression with a constant, trend and
two lags of consumption.
Dickey-Fuller regression with a constant, and four
lags of consumption.
Dickey-Fuller regression with a constant, trend, and
four lags of consumption.
Results in the above table indicate that there is no

unit root in the …rst di¤erence of consumption
series in a Dickey-Fuller regression with a constant.
From all the above tests, it follows that the

consumption series has a single unit root or the
consumption series is an I(1) process.
b). Perform a regression by OLS explaining

consumption from income. Test for cointegration
using two di¤erent tests.
OLS regression explaining consumption from income

results in Dickey-Fuller test of a unit root in the
residuals from the above OLS regression results in:
unit root in the residuals from an OLS regression
explaining consumption from income series and a
constant. Therefore, consumption and income series
are cointegrated.
The calculated value of the Cointegrating
Regression Durbin–Watson test or CRDW test is
given by:
The tabulated value of the CRDW test for 58
observation with two variables is close to 0.67 at
5% level of signi…cance. This indicates that the
Durbin-Watson d-statistic is signi…cantly di¤erent
from zero implying that consumption and income
series are cointegrated.
Phillips-Perron test in the above table also indicate
that there is no unit root in the residuals from an
OLS regression explaining consumption from income
series and a constant.
Therefore, consumption and income series are
cointegrated.
c). Perform a regression by OLS explaining income

from consumption. Test for cointegration.
OLS regression explaining income from consumption

results in Dickey-Fuller test of a unit root in the
residuals from the above OLS regression results in:
unit root in the residuals from an OLS regression
explaining income from consumption series and a
constant. Therefore, consumption and income series
are cointegrated.
The calculated value of the Cointegrating

Regression Durbin–Watson test or CRDW test is
given by:
The tabulated value of the CRDW test for 58
observation with two variables is close to 0.67 at
5% level of signi…cance. This indicates that the
Durbin-Watson d-statistic is signi…cantly di¤erent
from zero implying that income and consumption
series are cointegrated.
Phillips-Perron test in the above table also indicate

that there is no unit root in the residuals from an
OLS regression explaining income from consumption
series and a constant. Therefore, consumption and
income series are cointegrated.
d). Compare the estimation results and R 2 ’s from the

last two regressions.
Estimated coe¢ cients from the last two regressions

are all signi…cant and the estimated values of the
Durbin-Watson d-statistics are very close one
another. The values of R 2 ’s from the last two
regressions are identical.
e). Determine the error-correction term from one of the

two regressions and estimate an error-correction
model for the change in consumption. Test whether
the adjustment coe¢ cient is zero.
The error-correction term from the regression
consumption on income results in:
C 1476.017 .9071246Y
(.0073192)
For a VAR model of order 4, all information criteria

suggest an optimal lag length of 4. Therefore, the
estimated error-correction model for the change in
consumption is:
Test of signi…cance of the adjustment coe¢ cient is:
Results in the above table indicates that the
adjustment coe¢ cient in the estimated
error-correction model for the change in
consumption is negative and signi…cantly di¤erent
from zero.
f). Repeat the last question for the change in income.

What do you conclude?
As indicated the table given in part (e), test of

signi…cance of the adjustment coe¢ cient in the
estimated error-correction model for the change in
income is negative and but not signi…cantly di¤erent
from zero.
From the results in part (e) and (f) we may

conclude that the consumption variable has to
adjust to deviations from the long-run equilibrium
as the adjustment parameter in the error-correction
equation for the change in income is statistically
zero.
Since income does not adjust to the equilibrium
error, it is weakly exogenous for the cointegrating
parameters (as de…ned by Engle, Hendry and
Richard, 1983).

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Addis Ababa University

College of Business and Economics

Fantu Guta Chemrie (PhD)

For some country this relationship is estimated by OLS over

the years 1946-1995 (T=50). The results are given in Table 1

F. Guta (CoBE) Econ 654 September, 2017 2 / 40

economic models, positive autocorrelation is more likely than

F. Guta (CoBE) Econ 654 September, 2017 3 / 40

and the BLUE property.

d). Describe two di¤erent approaches to handle the

From now on, assume that St and Yt are nonstationary I(1)

f). Explain what we mean by ‘spurious regressions’.

h). Explain what we mean by a ‘cointegrating relationship’.

l). Explain intuitively why the estimator for a cointegrating

m). Assuming that St and Yt are cointegrated, describe what we

What do we learn from it?

n). How can we consistently estimate an error-correction model?

F. Guta (CoBE) Econ 654 September, 2017 6 / 40

The coe¢ cient estimate of 0.098 for the income variable is

interpreted as the saving rate, i.e., a 1% increase in income

results in a 0.098% increase in savings.

economic models, positive autocorrelation is more likely than

As can be seen from Table 1 above the value of DW-statistic

is smaller than two and this is an indication of a positive

autocorrelation. In economic models, positive autocorrelation

is more likely than negative autocorrelation because most of

the time the relationship between economic models is positive

than being negative. In this particular model, when income

increases, we anticipate an increase in savings.

c). What are the e¤ects of autocorrelation on the properties of

and the BLUE property.

In the presence of autocorrelation, OLS estimators remain

unbiased. However, OLS estimators are less e¢ cient, will no

longer be consistent and the standard errors are estimated in

the wrong way. Therefore, in the presence of autocorrelation,

OLS estimators will no longer be BLUE.

d). Describe two di¤erent approaches to handle the

In many cases the …nding of autocorrelation is an indication

that the model is misspeci…ed. If this is the case, the natural

route is to change model speci…cation. Typically, three

(interrelated) types of misspeci…cation may lead to a …nding of

autocorrelation in your OLS residuals: dynamic

misspeci…cation, omitted variables and functional form

The alternative approach to handle the autocorrelation

F. Guta (CoBE) Econ 654 September, 2017 10 / 40

The best approach to handle the problem of

e). Are there indications that the relationship between

Yes. The fact that DW < R 2 is a simple rule of

Consider two variables, Yt and Xt , generated by

The results from this regression are likely to be

Alternatively, when two nonstationary series does

g). Are there indications that there is a cointegrating

h). Explain what we mean by a ‘cointegrating

When two nonstationary series have the same

i). Describe two di¤erent tests that can be used to test

Suppose we estimate the ‘cointegrating regression’

and test whether γ1 = 0 (a unit root). However,

An alternative test for cointegration is based on the

j). How do you interpret the coe¢ cient estimate of

Under the hypothesis that St and Yt are

k). Are there reasons to correct for autocorrelation in

There are no reasons to correct for autocorrelation

l). Explain intuitively why the estimator for a