Econometrics 2 Fall 2005

Dynamic Regression Models for Stationary Variables

Heino Bohn Nielsen

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Outline
(1) Dynamic regression models for stationary variables.

The ADL model and special cases.

(2) Dynamic multipliers. (3) Long-run multipliers. (4) Error-correction model.

Long-run solution.
(5) Empirical example: ADL for consumption and income.

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Dynamic Models with Stationary Variables

Look at a conditional model for Yt | Y1, ..., Yt1, X1, ..., Xt1, Xt. A good starting point is the unrestricted autoregressive distributed lag (ADL) model Yt = + Yt1 + 0Xt + 1Xt1 + t. Yt is stationary is Xt is and the autoregressive polynomial is invertible, || < 1. Standard results for estimation and inference apply. E [ tXt] = 0 excludes feedback from Yt to Xt. We are interested in the dynamic inter-relations: Yt , Xt Yt+1 Xt , Yt+2 , ... Xt
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()

Some Special Cases

The ADL(1,1) model Yt = + Yt1 + 0Xt + 1Xt1 + t,
is simple but exible. It contains other relevant models as special cases.

0 = 1 = 0: AR(1) model Yt = + Yt1 + t. = 1 = 0: Static regression IID errors: Yt = + 0Xt + t. 1 = 0: Static regression with AR(1) errors. The specication + 0Xt + ut with ut = ut1 + 1 implies the COMFAC model Yt = Yt = + Yt1 + 0Xt 0Xt1 + t.
t

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Dynamic Multipliers
From the equations Yt = Yt+1 = Yt+2 = we can nd the dynamic
Yt Xt Yt+1 Xt Yt+2 Xt Yt+3 Xt Yt+k Xt

+ Yt1 + Yt + Yt+1 multipliers

Yt Xt1 Yt Xt2 Yt Xt3 Yt Xtk

+ 0Xt + 1Xt1 + + 0Xt+1 + 1Xt + + 0Xt+2 + 1Xt+1 + as the derivatives: 0

t t+1 t+2

= = = = . . =
t+1 = Y Xt t+2 = Y Xt

Yt = X + 1 = 0 + 1 t

= (0 + 1) = 2 (0 + 1) k1 (0 + 1) .

Due to stationarity, || < 1, shocks have transitory eects:

Yt+k 0 as k . Xt

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Examples of Dynamic Multipliers

1.2 1.0 0.8 0.6 0.4 0.2 0.0 -0.2 Y t =0.5 Yt 1 +0.8 X t +0.2 Xt 1 + t Y t =0.8 Yt 1 +0.8 X t +0.2 Xt 1 + t Y t =0.5 Yt 1 +0.8 X t +0.8 Xt 1 + t Y t =0.5 Yt 1 +0.8 X t 0.6 Xt 1 + t

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

22.5

25.0
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Long-Run Multiplier
Now consider a permanent shift in Xt, so that E [Xt] is changed. The nal eect in Yt is the long-run multiplier, given by the accumulated eect Yt Yt Yt Yt+1 Yt+2 Yt + + + ... = + + + ... Xt Xt1 Xt2 Xt Xt Xt = 0 + (0 + 1) + (0 + 1) + 2 (0 + 1) + ... = 0 1 + + 2 + ... + 1 1 + + 2 + ... + 1 . = 0 1 As an alternative derivation of the long-run eect, take expectations Yt = + Yt1 + 0Xt + 1Xt1 + t E [Yt] = + E [Yt1] + 0E [Xt] + 1E [Xt1] E [Yt] (1 ) = + (0 + 1) E [Xt] + 1 + 0 E [Xt]. E [Yt] = 1 1

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General Case
Consider the general case ADL(p,q): (L)Yt = + (L)Xt + t,
where

(L) = 1 1L 2L2 ... pLp (L) = 0 + 1L + 2L2 + ... + q Lq .

Under stationarity, the long-run solution can be found as Yt = 1(L) + 1(L)(L)Xt + 1(L) E [Yt] = 1(L) + 1(L)(L)E [Xt] .
t

Since E [Yt] = E [Yt1] = LE [Yt] and E [Xt] = E [Xt1] = LE [Xt] we nd the long-run multiplier

1(1)(1) =

(1) 0 + 1 + 2 + ... + q . = (1) 1 1 2 ... p

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Examples of Long-Run Multipliers

5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 2.5 5.0 7.5 10.0 12.5 15.0 17.5 20.0 22.5 25.0
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Y t =0.5 Yt 1 +0.8 X t +0.2 Xt 1 + t Y t =0.8 Yt 1 +0.8 X t +0.2 Xt 1 + t Y t =0.5 Yt 1 +0.8 X t +0.8 Xt 1 + t Y t =0.5 Yt 1 +0.8 X t 0.6 Xt 1 + t

The Error Correction Model

An alternative formulation which incorporates the long-run solution is the ECM: Yt = Yt Yt1 = Yt Yt1 = Yt =
or alternatively

+ Yt1 + 0Xt + 1Xt1 + t + ( 1)Yt1 + 0Xt + 1Xt1 + t + ( 1)Yt1 + 0(Xt Xt1) + (0 + 1)Xt1 + + ( 1)Yt1 + 0Xt + (0 + 1)Xt1 + t

Yt = 0Xt (1 ) Yt1

+ 1 0 Xt1 + 1 1 | {z } | {z }

So Yt reacts on deviations from the long-run solution

It error-corrects or equilibrium-corrects. Yt = + Xt is the attractor.
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Yt Yt = Yt Xt.

Empirical Example: Consumption and Income

We consider growth in consumption and income, ct and yt, for Denmark. An ADL(1,1) yields the following: Modelling dc by OLS for 1971 (3) to 2004 (2) Coefficient -0.327845 0.00321307 0.228831 0.0924352 Std.Error 0.08455 0.001539 0.06015 0.06234 t-value -3.88 2.09 3.80 1.48

dc_1 Constant dy dy_1

sigma 0.0170843 R^2 0.17001 log-likelihood 351.917 no. of observations 132 mean(dc) 0.00333392

RSS 0.0373599307 F(3,128) = 8.74 [0.000]** DW 2 no. of parameters 4 var(dc) 0.000341004

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Apart from outliers, the model is reasonably well specied: AR 1-5 test: ARCH 1-4 test: Normality test: RESET test: F(5,123) F(4,120) Chi^2(2) F(1,127) = = = = 0.65106 0.87746 31.888 2.4628 [0.6612] [0.4797] [0.0000]** [0.1191]

The long-run solution is derived in PcGive: Solved static long-run equation for dc Coefficient Std.Error Constant 0.00241977 0.001152 dy 0.241946 0.07313 where

t-value 2.10 3.31

0 + 1 0.228831 + 0.0924352 = = 0.24195. 1 1 + 0.327845 The standard error is a complicated function of the covariances. =
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Consumption growth 0.10 0.05 0.05 0.00 0.00 -0.05 1970 1980 1990 2000

Income growth

-0.05 1970

1980

1990

2000

Residuals 2.5 0.0 -2.5 0.0 1970 1980 1990 2000 0.2

Cumulated dynamic multipliers (scaled) Cumulated dynamic multipliers

0.1 Dynamic multiplier (lag-weights) 0 5 10

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