Granger Causality

Guy Lion
December 2005
 Granger Causality vs “Causality”
• Granger causality measures whether A
happens before B and helps predict B.

• A Granger causing B may entail

“real”causality. But, you can’t be sure.

• If A does not Granger cause B. You can be

more confident, A does not cause B.
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 Granger Causality steps
1. Develop a Base case autoregressive model using
dependent variable and its lagged values as independent
variable.
2. Develop a Test case model by adding a second lagged
independent variable you want to test.
3. Calculate the square of the residual errors for the two
models and run an F test or t Test (unpaired) to check if
the residuals are significantly lower when you add tested
second variable.
4. Redo steps 1 through 3, but reverse the direction. By
comparing the tests significance or P value, you can see
if A Granger causes B more than B Granger causes A.
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 The Basic Picture
A Granger causes B
Linear Regression

Base case Model Test Model

Autoregressive Multivariate
X1 = Lag B X1 = Lag B
Y=B X2 = Lag A Independent
Y=B Variable
being tested
Square Residuals Square Residuals

Hypothesis testing
F or t Test
Do the 2 samples of
residuals come from
same population?
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 The Whole Picture

A Granger causes B B Granger causes A

Linear Regression Linear Regression

Base case Model Test Model Base case Model Test Model
Autoregressive Multivariate Autoregressive Multivariate
X1 = Lag B X1 = Lag B X1 = Lag A X1 = Lag A
Y=B X2 = Lag A Y=A X2 = Lag B
Y=B Y=A

Square Residuals Square Residuals Square Residuals Square Residuals

Hypothesis testing Hypothesis testing

F or t Test F or t Test
Do the 2 samples of Do the 2 samples of
residuals come from residuals come from
same population? same population?

Granger Causality
Compare significance of F or t Stat P value to
find out if A causes B more than B causes A.

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 Does Loan  Granger
cause Deposit 
Correlation
Since mid 1987 Let’s test if Loan  Granger
All loans causes Deposit . We will
All use Loan  with a 4 quarter
deposits lag since it has the highest
Current 0.52 correlation with Deposit .
Lag 1 0.15
Lag 2 0.43
Lag 3 0.07
Data source: quarterly basis since 2 nd
Lag 4 0.61 quarter of 1987. Total loans and total
deposits aggregated from Fed Data
Flow of Funds Accounts (L109, L215,
L216, L217, L222).
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 t Test (unpaired) (Loans cause Deposits)

Unpaired t Test (large sample formula)

Input Base Test The Test model achieved
Model Model a higher adjusted R
Sample size 72 72 Square of 0.41 vs the
Avg. of square residuals 0.012% 0.010%
Standard deviation 0.016% 0.013%
Base case model’s 0.28.
Standard error 0.002% 0.001%
A Average difference 0.002%

Output
B Group standard error 0.002%
A/B t statistic 0.92 (nbr. of stand. errror)
Degree of freedom 142
Group's t statistics:
P Value, prob. population are same:
a) One tail 17.8%
b) Two tail 35.7%
Using normal distribution 35.5% Using NORMDIST

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 t Test (unpaired) (Deposits cause Loans)

Unpaired t Test (large sample formula)

Input
The Test model
Base Test
Model Model achieved a lower
Sample size 72 72 adjusted R Square of
Avg. of square residuals 0.003% 0.003% 0.45 vs the Base
Standard deviation 0.006% 0.006% case model’s 0.46.
Standard error 0.001% 0.001%
A Average difference 0.000%

Output
B Group standard error 0.001%
A/B t statistic 0.000 distance (nbr. of stand. errror)
Degree of freedom 142
Group's t statistics:
P Value, prob. population are same:
a) One tail 49.99%
b) Two tail 99.98%
Using normal distribution 99.98% Using NORMDIST

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 Loans  Granger causes Deposits 
more than the reverse
Loans  cause Deposits  Deposits  cause Loans 
Base Test Base Test
Variables model model model model
Dependent Y Deposit  Deposit  Loan  Loan 
Independent X1 Lagged " Lagged " Lagged " Lagged "
Independent X2 Lagged Loan  Lagged Deposit 

Regression Statistics
Adj. R Square 0.28 0.41 0.46 0.45
Standard Error 1.11% 1.01% 0.59% 0.60%

Testing if Square Residuals coming from same population.

Significance of F 35.7% 99.98%
t test P value 35.7% 99.98%

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