Violations of assumptions of the CLRM

Autocorrelation of errors
• This assumption tells us that the error term at time t is not
correlated with the error term at any other point of time.

• This assumption tells us that the error term at time t is not

correlated with the error term at any other point in the past or
there is no relationship between the current and past
values of a time series (variable), that is, there is no carry-
over effect.

• In case of cross-sectional data (e.g., income and

expenditure of different households), this assumption is
plausible since the expenditure behaviour of one household
does not affect that of any other household in general.
• The assumption of no autocorrelation is more frequently
violated in case of relations estimated from time series data.

• For instance, non-autocorrelation simply means the fact that

the price of an asset is higher than expected today should not
lead to a higher (or lower) than expected price tomorrow.

• Generally, this is unrealistic since future prices are often

correlated with current and past prices.

• Moreover, an underestimate for one quarter’s profits can

result in an underestimate of profits for subsequent quarters.

• Thus, the assumption of non-autocorrelation does not seem

plausible here.
Tests for the presence of error
autocorrelation
Some of the limitations of the DW test are:

• There is a region where the test is inconclusive

• The test is valid only for the AR(1) error scheme

• The test is invalid when lagged values of the dependent

variable appear as regressors
Some of the advantages of the BG test are:

• The test is always conclusive

• The test is applicable for higher order AR schemes (not

just for AR(1) error scheme)

• The test is valid when lagged values of the dependent

variable appear as regressors
Correcting for error autocorrelation
The fitted model of investment on value of outstanding shares is
shown below:
Autocorrelation diagnostics in EViews
To get a scatter diagram of the residuals, click on Quick and
select Graph…
Type resid under Series List
Click on OK and select Dot Plot.
Click on OK to get the scatter diagram. To draw a reference line
(at zero), click on Line/Shade.
Select Horizontal – Left axis under Orientation, and type 0 in
the box adjacent to Data value.
Click on OK. We can see a clustering of neighbouring residuals
on one or the other side of the y-axis.

This might be a sign that the errors are autocorrelated.

• One of the statistics displayed in EViews output is the
Durbin-Watson (DW) test statistic.

• This statistic is equal to d = 0.552764.

• Note that the p-value of the test is not provided since

the test is non-standard.

• We have to refer to the tables of DW critical values.

To get the Breusch-Godfrey test of error autocorrelation, click on
View in the equation window, select Residual Diagnostics and
then Serial Correlation LM Test…
Leave the Lag Specification at its default and click on OK to
view the output of this test.

Since the p-values of both versions of the test (F-test and Chi-
square test) are less than 0.05, we reject the null hypothesis of
no autocorrelation.
To get the plot of the partial autocorrelation function (PACF) at
various lags, click on View in the equation window, select
Residual Diagnostics and then Correlogram- Q-statistics…
Type 5 for Lag Specification and click on OK to view the PACF.
• We can see that the PACF at lag one extends beyond
the 95% upper confidence limit.

• The PACF at higher lags is within the confidence limits.

• This is an indication that the errors follow the AR(1)

process:

𝜀𝑡 = 𝜌𝜀𝑡−1 + 𝑢𝑡
Correcting for autocorrelation
First you need to save the OLS residuals using another name.
To do so, click on Genr, type the following and then click on OK:

residual=resid
Click on Quick and select Estimate Equation…

Under Equation specification box, type the following:

residual residual(-1)
Click on OK to get the results of the fitted model.

An estimate of ρ is 0.805.
To transform the dependent variable, click on Genr, type the
following and then click on OK:

invest_tran = invest - 0.805*invest(-1)

To transform the independent variable, click on Genr, type the
following and then click on OK:

vos_tran = vos - 0.805*vos(-1)

EViews output of OLS regression of invest_tran on vos_tran is
shown below:
The PACF of the residuals in the transformed model is shown
below.

We can see the partial correlation of the residuals at all lags lie
within the upper and lower confidence limits – an indication that
the autocorrelation structure has been properly dealt with.
The Breusch-Godfrey test results are shown below.

The null hypothesis of no autocorrelation cannot be rejected

since the p-values of both versions of the test exceed 0.05.