Vector autoregression (VAR)

Introduction
• Let’s consider a system of two variables

• ------------(16.8)

---------(16.9)

• where TB3 and TB6 are three and six-month T-bill rates, and where the us are
white noise error terms, called impulses or innovations or shocks in the
language of VAR.
• Notice these features of the bivariate VAR given in the preceding equations:
• 1. The bivariate system resembles a simultaneous equation system, but the
fundamental difference between the two is that each equation contains only its
own lagged values and the lagged values of the other variables in the system.
• But no current values of the two variables are included on the right-hand side
of these equations.
• 2. Although the number of lagged values of each variable can be different, in
most cases we use the same number of lagged terms in each equation
• 3 The bivariate VAR system given above is known as a VAR(p) model, because
we have p lagged values of each variable on the right-hand side.
• If we had only one lagged value of each variable on the right-hand side, it
would be a VAR(1) model; if two-lagged terms, it would be a VAR(2) model; and
so on.
• 4. Although we are dealing with only two variables, the VAR system can be
extended to several variables.
• Suppose we introduce another variable, say, the Federal Funds rate. Then we
will have a three-variable VAR system, each equation in the system containing p
lagged values of each variable on the right-hand side of each equation.
• 5. But if we consider several variables in the system with several lags for each
variable, we will have to estimate several parameters, which is not a problem in
this age of high-speed computers and sophisticated software, but the system
becomes quickly unwieldy.
• 6 In the two-variable system of Eqs. (16.8) and (16.9), there can be at most one
cointegrating, or equilibrium, relationship between them. If we have a three-
variable VAR system, there can be at most two cointegrating relationships
between the three variables.
• In general, an n-variable VAR system can have at most (n – 1) cointegrating
relationships.
• Since our objective here is to introduce the basics of VAR, we will stick with the
two-variable VAR system.
• Since we have 349 monthly observations on the two Treasury bill rates, we have
much freedom about the number of lagged terms we can introduce in the
model.
• Introducing too few lagged terms will lead to specification errors.
• Introducing too many lagged terms will consume several degrees of freedom,
not to mention the problem of collinearity.
• So we will have to proceed by trial and error and settle on the number of lagged
terms on the basis of the Akaike or Schwarz information criteria.
• Since financial markets are supposed to be efficient, we need not introduce too
many lagged terms in the two equations.
• Whatever the choice of the lagged terms introduced in the two equations, a critical
requirement of VAR is that the time series under consideration are stationary.
• Here we have three possibilities:
• First, both TB3 and TB6 time series are individually I(0), or stationary. In that case
we can estimate each equation by OLS.
• Second, both TB3 and TB6 are I(1) then we can take the first differences of the
two variables, which, as we know, are stationary. Here too we can use OLS to
estimate each equation individually.
• Third, if the two series are I(1), but are cointegrated, then we have to use the
error correction mechanism (ECM). Recall that ECM combines the long-run
equilibrium with short-run dynamics to reach that equilibrium.
• Since we are dealing with more than one variable in a VAR system, the
multivariate counterpart of ECM is known as the vector error correction model
(VECM).
• Now the estimation of the VAR system given in Eqs. (16.8) and (16.9), using the
VECM approach, involves three steps:
• Step 1: We first estimate the cointegrating relation between the two rates. We
know that the cointegrating relation is given by

• The results of this regression are given in Table 16.10. These results show that,
allowing for linear and quadratic trends, there is a statistically significant positive
relationship between the two rates.
• If TB3 goes up by 1 percentage point, on average, TB6 goes up by about 0.96
percentage points, ceteris paribus.
• Step 2: From this regression we obtain the residuals, et, which are given by the
relation:

• Provided that et is stationary, we know that et in Eq. (16.11) is the error

correction (EC) term
• Step 3: Now we estimate (16.8) and (16.9) using the EC term as follows, which is
the VEC model:
-------(16.12)
-------(16.13)
• You will see how VEC ties short-run dynamics to long-run relations via the EC
term.

• In these two equations, the slope coefficients are known as error correction
coefficients, for they show how much %TB6 and %TB3 adjust to “equilibrating”
error in the previous period, et–1.

• Notice carefully how the short-term behavior of the two TB rates is linked to
their long-term relationship via the EC term. If, for example, alpha 2 is positive,
TB6 was below its equilibrium value in the previous period and hence in the
current period it must be adjusted upward.
• On the other hand, if it is negative, TB6 was above its equilibrium value so that
in the current period it will be adjusted downward. Similar comments apply to
TB3.
• It should be noted that the slope coefficients in the preceding two regressions
will have opposite signs because there is only one equilibrium relation between
the two rates.
Forecasting with VAR
Let’s consider a VAR (1) model, which is:
---------(16.16)

---------(16.17)

where t is the trend variable. Having estimated the two-variable VAR, we denote
the estimated values of the coefficients by as and bs. We obtained these
estimates using the sample data from time period 1 to end of time period (t).
Now suppose we want to forecast the values of TB3 TB6 beyond sample period, t
+ 1, t + 2, ..., (t + n), where n is specified.
• We can proceed as following, using TB3. The forecast for time (t + 1) is given by
• -------- (16.18)
• Since we do not know what the value of the error term in period (t + 1) will be,
we put it equal to zero because u is random anyhow.
• We do not know the parameter values either, but we can use the estimated
values of these parameters from the sample data. So we actually estimate

• Thus, to forecast TB3 in period t + 1, we use the actual values of TB3 and TB6 in
period t, which is the last observation in the sample. Note that, as usual, a hat
over a symbol represents an estimated value.
• We follow the same procedure to forecast TB6 in period (t + 1), namely,

• To forecast TB3 for period t + 2, we follow the same procedure, but modify it as
follows:

• Notice carefully that in this equation we use the forecast values of TB3 and TB6
from the previous period and not the actual values because we do not know
them.
• As you can sense, this procedure produces dynamic forecasts.
• Also, note that if we make a forecast error in the first period, that error will be
carried forward because, after the first period of forecast, we use the forecast
value in the previous period as input on the right-hand side of the above
equation.
Testing causality using VAR: the Granger
causality test
• In regression analysis, the distinction between the dependent variable Y and
one or more X variables, the regressors, does not necessarily mean that the X
variables “cause” Y.
• “Causality between them, if any, must be determined externally, by appealing
to some theory or by some kind of experimentation time does not run
backward. That is, if event A happens before event B, then it is possible that A is
causing B. However, it is not possible that B is causing A. In other words, events
in the past can cause events to happen today, future events cannot.”
• This line of thinking is behind the so-called Granger causality test
• To explain the Granger causality test, we will look at the consumption function
example discussed in Section 16.1 from the point of Granger causality.
• The question we now ask is: What is the relationship between per capita personal
consumption expenditure
• (PCE) and per capita personal disposable income (PDI), both expressed in real
term (2005 chained dollars)?Does PCE &PDI or does PDI &PCE, where the arrow
points to the direction of causality?
• For empirical purposes, we will use the logs of these variables because the slope
coefficients can be interpreted as elasticities.
• The Granger test involves estimating the following pairs of regressions:
• --------- (16.22)

• ----------- (16.23)
• where L stands for logarithm and t is the time or trend variable and where it is
assumed that the error terms u1t and u2t are uncorrelated.
• Notice that the two equations represent a bivariate VAR. Each equation
contains the lags of both variables in the system; the number of lagged terms
included in each equation is often a trial and error process.
• Now we distinguish four cases.
• 1 Unidirectional causality from LPCE to LPDI (LPCE &LPDI) occurs if the estimated in
Eq. (16.23) are statistically different from zero as a group and the set of estimated )
coefficients in Eq. (16.22) is not different from zero.
• 2 Unidirectional causality fromLPDI to LPCE (LPDI &LPCE) is indicated if the set of
coefficients in Eq. (16.22) is statistically different from zero and the set of is not
statistically different from zero.
• 3 Feedback or bilateral causality is indicated when the sets of LPCE and LPDI coefficients
are statistically significantly different from zero in both regressions.
• 4 Independence is suggested when the sets of LPCE and LPDI coefficients are not
statistically significant in either of the regressions.
• To implement the test, consider regression (16.22). We proceed as follows:
• 1. Regress current LPCE on all lagged LPCE terms and other variables, if any
(such as trend), but do not included the lagged LPDI terms in this regression.
We call this the restricted regression. From this regression we obtain the
restricted residual sum of squares, RSSr.
• 2 Now reestimate Eq. (16.22) including the lagged LPDI terms. This is the
unrestricted regression. From this regression obtain the unrestricted residual
sum of squares, RSSur.
• 3 The null hypothesis H0 is that: that is, the lagged LPDI
terms do not belong in the regression.
• 4. To test the null hypothesis, we apply the F test, which is:
• ---------- (16.24)

• which has m and (n – k) df, where m is the number of lagged LPDI terms, k is the
number of parameters estimated in the unrestricted regression, and n is the
sample size.
• 5. If the computed F value exceeds the critical F value at the chosen level of
significance, we reject the null hypothesis. In this case the LPDI lagged terms
belong in the LPCE equation, which is to say LPD causes LPCE.
• These steps can be repeated for Eq. (16.23) to find out if LPCE causes LPDI.
• Before we implement the Granger test, we need to consider several factors:
• 1. The number of lagged terms to be introduced in the Granger causality tests is
an important practical question, for the direction of causality may depend
critically on the number of lagged terms included in the model.
• We will have to use the Akaike, Schwarz or similar criterion to determine the
length of the lags. Some trial and error is inevitable.
• 2. We have assumed that the error terms entering the Granger test are
uncorrelated. If this is not the case, we will have to use appropriate error
transformation as discussed in the chapter on autocorrelation.
• 3. We have to guard against “spurious” causality. When we say that LPCE causes
LPDI (or vice versa), it is quite possible that there is a “lurking” variable, say
interest rate, that causes both LPCE and LPDI. Therefore the causality between
LPCE and LPDI may in fact be due to the omitted variable, the interest rate.
• One way to find this out is to consider a three-variable VAR, one equation for
each of the three variables.
• 4. The critical assumption underlying the Granger causality test is that the
variables under study, such as LPCE and LPDI, are stationary. In our case, it can
be shown that both LPCE and LPDI are individually nonstationary. So, strictly
speaking, we cannot use the Granger test
• 5. However, while individually nonstationary, it is possible that the variables in
question are cointegrated.
• In that situation, as in the case of univariate nonstationary variables, we will
have to use the error correction mechanism (ECM).
• This is because if LPCE and LPDI are cointegrated, then following the Granger
Representation Theorem, either LPCE must cause LPDI or LPDI must cause LPCE.
• To see if LPCE and LPDI are cointegrated, we estimated the (cointegrating)
regression of Table 16.11. This regression shows that the elasticity of PCE with
respect to PDI is about 0.71, which is statistically significant.
• The trend coefficient, which is also statistically significant, suggests that the rate
of growth in LPCE is about 0.76% per year.
• When the residuals from this regression were tested for unit root, it was found
that the residuals were stationary.
• Therefore, we can conclude that the two time series, while individually
nonstationary, are cointegrated.
• In view of this finding we can conduct the Granger causality test, but we must
use the error correction mechanism.

• where %, as usual, is the first difference operator and where et–1 is the lagged
residual term from the cointegrating regression given in Table 16.11, which is
nothing but the error correction (EC) term.
• As is clear from Eq. (16.25), there are now two sources of causation for LPCE: (1)
through the lagged values of LPDI and/or (2) through the lagged value of the
cointegrating vector (i.e. the EC term). The standard Granger test neglects the
latter source of causation.
• Therefore the null hypothesis
• can be rejected if any of these coefficients are nonzero . In other words, even if
all the ) coefficients are zero, but the coefficient of the lagged EC term is
nonzero,we can reject the hypothesis that LPDI does not cause LPCE.
• This is because the EC term includes the impact of LPDI.