A E T S F E: Pplied Conometric IME Eries Ourth Dition

APPLIED ECONOMETRIC
TIME SERIES
FOURTH EDITION
Chapter 1: Difference Equations
WALTER ENDERS, UNIVERSITY OF ALABAMA
Copyright 2015 John, Wiley & Sons, Inc. All rights reserved.
Section 1
TIME-SERIES MODELS
The traditional use of time series models was

for forecasting
If we know
yt+1 = a0 + a1yt + t+1
then
Etyt+1 = a0 + a1yt
and since
yt+2 = a0 + a1yt+1 + t+2
Etyt+2 = a0 + a1Etyt+1
= a0 + a1(a0 + a1yt)
= a0 + a1a0 + (a1)2yt
Capturing Dynamic Relationships

With the advent of modern dynamic economic models, the
newer uses of time series models involve
Capturing dynamic economic relationships
Hypothesis testing
Developing stylized facts
In a sense, this reverses the so-called scientific method
in that modeling goes from developing models that
follow from the data.
The Random Walk Hypothesis

yt+1 = yt + t+1
or
yt+1 = t+1
where yt = the price of a share of stock on day t, and t+1 = a

random disturbance term that has an expected value of zero.
Now consider the more general stochastic difference equation
yt+1 = a0 + a1yt + t+1
The random walk hypothesis requires the testable restriction:
a0 = a1 = 0.
The Unbiased Forward Rate (UFR)

hypothesis
Given the UFR hypothesis, the forward/spot exchange rate relationship is:
st+1 = ft + t+1
(1.6)
where t+1 has a mean value of zero from the perspective of time period t.
Consider the regression
st+1 = a0 + a1ft + t+1
The hypothesis requires a0 = 0, a1 = 1, and that the regression residuals t+1 have a
mean value of zero from the perspective of time period t.
The spot and forward markets are said to be in long-run equilibrium when t+1 =
0. Whenever st+1 turns out to differ from ft, some sort of adjustment must occur to
restore the equilibrium in the subsequent period. Consider the adjustment process
st+2 = st+1 a[ st+1 ft ] + st+2 a > 0
(1.7)
ft+1 = ft + b [ st+1 ft ] + ft+1 b > 0
(1.8)
where st+2 andeft+1 both have an expected value of zero.
Trend-Cycle Relationships
We can think of a time series as being composed of:
yt = trend + cycle + noise
Trend: Permanent
Cycle: predictable (albeit temporary)
(Deviations from trend)
Noise: unpredictable
Series with decidedly upward trend

15000
Trillions of 2005 dollars
12500
10000
7500
5000
2500
0
1950
1960
GDP
1970
1980
Potential
1990
2000
Consumption
Figure 3.1 Real GDP, Consumption and Investment
2010
Investment
GDP Volatility?
20
15
Percent per year
10
-5
-10
-15
1950
1960
1970
1980
1990
2000
Figure 3.2 Annualized Growth Rate of Real GDP

2010
Stock Market Volatility

12.5
10.0
7.5
percent change
5.0
2.5
0.0
-2.5
-5.0
-7.5
-10.0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Figure 3.3: Daily Changes in the NYSE US 100 Index: (Jan 4, 2000 - July 16, 2012)
Co-Movements
16
14
percent per year
12
10
8
6
4
2
0
1960
1965
1970
1975
1980
1985
T -bill
1990
1995
2000
5-year
Figure 3.4 Short- and Long-Term Interest Rates
2005
2010
Common Trends
2.25
2.00
currency per dollar
1.75
1.50
1.25
1.00
0.75
0.50
2000
2002
2004
Euro
2006
2008
Pound
2010
Sw iss Fr
Figure 3.5: Daily Exchange Rates (Jan 3, 2000 - April 4, 2013)

2012
Section 2
DIFFERENCE EQUATIONS AND

THEIR SOLUTIONS
Consider the function yt* = f(t*)

yt* h f (t * h ) f (t*)
y t * h y t *
We can then form the first differences:
yt = f(t) f(t1) yt yt1
yt+1 = f(t+1) f(t) yt+1 yt
yt+2 = f(t+2) f(t+1) yt+2 yt+1
More generally, for the forcing process xt a n-th order linear process is
n
y t a 0 ai y t i xt
i 1
What is a solution?
A solution to a difference equation expresses the value
of yt as a function of the elements of the {xt} sequence
and t (and possibly some given values of the {yt}
sequence called initial conditions).
n
y t a 0 ai y t i x t
i 1
The key property of a solution is that it satisfies the

difference equation for all permissible values of t and
{xt}.
Section 3
Iteration without an Initial Condition
Reconciling the Two Iterative Methods
Nonconvergent Sequences
SOLUTION BY ITERATION
Solution by Iteration
Consider the first-order equation
yt = a0 + a1yt1 + t
(1.17)
Given the value of y0, it follows that y1 will be given b

y1 = a0 + a1y0 + 1
In the same way, y2 must be
y2 = a0 + a1y1 + 2
= a0 + a1[a0 + a1y0 + 1] + 2
= a0 + a0a1 + (a1)2y0 + a11 + 2
Continuing the process in order to find y3, we obtain
y3 = a0 + a1y2 + 3
= a0[1 + a1 + (a1)2] + (a1)3 y0 + a121 + a12 + 3
From
y3 = a0[1 + a1 + (a1)2] + (a1)3 y0 + a121 + a12 + 3
you can verify that for all t > 0, repeated iteration yields
t 1
t 1
yt a0 a a y0 aii t i
i 0
i
i
t
1
i 0
If | a1 | < 1, in the limit
y t a0 /(1 a1 ) a1i t i
i 0
Backwards Iteration
Iteration from yt back to y0 yields exactly the formula given
by (1.18).
Since yt = a0 + a1yt1 + t, it follows that
yt = a0 + a1 [a0 + a1yt2 + t1] + t
= a0(1 + a1) + a1t1 + t + a12[a0 + a1yt3 + t2]
If | a1 | < 1, in the limit
y t = a 0 / (1 a1 ) + a 1i t -i
i= 0
Section 4
The Solution Methodology
Generalizing the Method
AN ALTERNATIVE
SOLUTION METHODOLOGY
Does it converge? Characteristic Roots

Since the intercept and the t sequence have nothing to do
with the issue of convergence, consider:
yt = a1yt1
A solution is
yt = A(a1)t
Aa1t a1 Aa1t 1
Proof:
If a1 < 1, the yt converges to zero as t approaches infinity.

Convergence is direct if 0 < a1 < 1 and oscillatory if 1 < a1 < 0.
If a1 > 1, the homogeneous solution is not convergent. If a1 > 1, yt
approaches as t increases. If a1 < 1, the yt oscillates explosively.
If a1 = 1, any arbitrary constant A satisfies the homogeneous equation
yt = yt1. If a1 = 1, the system is meta-stable: = 1 for even values of t
and 1 for odd values of t.
Generalizing the Method

n
y t ai y t i
i 1
A t a1A t-1 a2At-2 anA t-n = 0

There are n roots
In the nth-order case
yth = A1(1)t + A2(2)t +

For convergence, all of the roots must be less than unity in absolute value (or
inside the unit circle if complex).
In an nth-order equation, a necessary condition for all characteristic roots to lie inside the unit
circle is
n
a
i 1
Since the values of the ai can be positive or negative, a sufficient condition for all
characteristic roots to lie inside the unit circle is
n
| a
i 1
| 1
At least one characteristic root equals unity if

n
a 1
i
i 1
Any sequence that contains one or more characteristic roots that equal unity is
called a unit root process.
For a third-order equation, the stability conditions can be written as
1 a1 a2 a3 > 0
1 + a1 a2 + a3 > 0
1 a1a3 + a2 a32 > 0
3 + a1 + a2 3a3 > 0 or 3 a1 + a2 + 3a3 > 0
Given that the first three inequalities are satisfied, one of the last conditions is
redundant.
The Solution Methodology

STEP 1: form the homogeneous equation and find all n
homogeneous solutions;
STEP 2: find a particular solution;
STEP 3: obtain the general solution as the sum of the particular
solution and a linear combination of all homogeneous solutions;
STEP 4: eliminate the arbitrary constant(s) by imposing the initial
condition(s) on the general solution.
Section 5
Stability Conditions
Higher-Order Systems
THE COBWEB MODEL
Setting supply equal to demand:

b + pt1 + t = a pt
or
pt = (/)pt1 + (a b)/ t/
The homogeneous equation is pt = (/)pt1.

If the ratio / is less than unity, you can iterate (1.39) backward
from pt to verify that the particular solution for the price is
ab 1
p
( / )i t i
i 0
p
t
Stability requires | / | < 1
Section 6
Stability Conditions
Higher-Order Systems
SOLVING HOMOGENEOUS
DIFFERENCE EQUATIONS
Consider the second-order equation

yt a1yt1 a2yt2 = 0
A t a1A t-1 a2A t-2 = 0
If you divide (1.46) by At2, the problem is to find the values of
that satisfy
2 a1 a2 = 0
There are two characteristic roots. Hence the homogeneous
solution is
A1(1)t + A2(2)t
THE THREE CASES

CASE 1
If a12 + 4a2 > 0, d is a real number and there will be two
distinct real characteristic roots.
CASE 2
If + 4a2 = 0, it follows that d = 0 and a1 = a2 = a1/2.
A homogeneous solution is a1/2. However, when d = 0,
there is a second homogeneous solution given by t(a1/2)t.
CASE 3
If a12 + 4a2 < 0, it follows that d is negative so that the
characteristic roots are imaginary.
WORKSHEET 1.1: SECOND-ORDER EQUATIONS

Example 1: yt = 0.2yt-1 + 0.35yt2. Hence: a1 = 0.2 and a2 = 0.35
Form the homogeneous equation: yt 0.2yt1 0.35yt2 = 0
d = + 4a2 so that d = 1.44. Given that d > 0, the roots will be real and distinct. Substitute yt = t into
the homogenous equation to obtain: t 0.2t1 0.35t2 = 0
Divide by t2 to obtain the characteristic equation: 2 0.2 0.35 = 0
Compute the two characteristic roots: 1 = 0.7
2 = 0.5
The homogeneous solution is: A1(0.7)t + A2(0.5)t.

Example 2: yt = 0.7yt-1 + 0.35yt2. Hence: a1 = 0.7 and a2 = 0.35
Form the homogeneous equation: yt 0.7yt-1 0.35yt2 = 0
Thus d = + 4a2 = 1.89. Given that d > 0, the roots will be real and distinct. Form the characteristic
equation t 0.7t1 0.35t2 = 0
Divide by t2 to obtain the characteristic equation: 2 0.7 0.35 = 0
Compute the two characteristic roots: 1 = 1.037
2 = 0.337
The homogeneous solution is: A1(1.037)t + A2(0.337)t.

Section 8
THE METHOD OF UNDETERMINED

COEFFICIENTS
The Method of Undetermined Coefficients

Consider the simple first-order equation: yt = a0 + a1yt1 + t
Posit the challenge solution:
y t = b0 + i t i
i=0
b0 + a0t + a1t1 + a2t2 + = a0 + a1[b0 + a0t1 + a1t2 + ] + t
0 1 = 0
a1 a1a0 = 0
a2 a1a1 = 0
b0 a0 a1b0 = 0
a0
a1i t i
yt
1 a1 i 0
The Method of Undetermined Coefficients II

Consider:
yt = a0 + a1yt1 + a2yt2 + t
(1.68)
Since we have a second-order equation, we use the challenge solution

yt = b0 + b1t + b2t2 + a0t + a1t1 + a2t2 +
where b0, b1, b2, and the ai are the undetermined coefficients. Substituting the
challenge solution into (1.68) yields
[b0+b1t+b2t2] + a0t + a1t1 + a2t2+ = a0 + a1[b0 + b1(t 1) + b2(t 1)2
+ a0t1 + a1t2 + a2t3 + ] + a2[b0 + b1(t 2) + b2(t 2)2
+ a0t2 + a1t3 + a2t-4 + ] + t
Hence:
a0 = 1
a1 = a1a0
a2 = a1a1 + a2a0
a3 = a1a2 + a2a1
[so that a1 = a1]

[so that a2 = (a1)2 + a2]
[so that a3 = (a1)3 + 2a1a2]
Notice that for any value of j 2, the coefficients solve the second-order
difference equation aj = a1aj1 + a2aj2.
Section 9
Lag Operators in Higher-Order Systems
LAG OPERATORS
Lag Operators
The lag operator L is defined to be:
Liyt = yt-i
Thus, Li preceding yt simply means to lag yt by i periods.
The lag of a constant is a constant: Lc = c.
The distributive law holds for lag operators. We can set:
(Li + Lj)yt = Liyt + Ljyt = yt-i + yt-j
Lag Operators (contd)
Lag operators provide a concise notation for writing difference

equations. Using lag operators, the p-th order equation
yt = a0 + a1yt-1 + ... + apyt-p + t can be written as:

(1 - a1L - a2L2 - ... - apLp)yt = t
or more compactly as:
A(L)yt = t
As a second example,
yt = a0 + a1yt-1 + ... + apyt-p + t + 1t-1 + ... + qt-q as:
A(L)yt = a0 + B(L)t
where: A(L) and B(L) are polynomials of orders p and q, respectively.
APPENDIX 1.1: IMAGINARY ROOTS

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APPLIED ECONOMETRIC

Chapter 1: Difference Equations

WALTER ENDERS, UNIVERSITY OF ALABAMA

The traditional use of time series models was

Capturing Dynamic Relationships

The Random Walk Hypothesis

where yt = the price of a share of stock on day t, and t+1 = a

The Unbiased Forward Rate (UFR)

Series with decidedly upward trend

Trillions of 2005 dollars

Figure 3.1 Real GDP, Consumption and Investment

Percent per year

Figure 3.2 Annualized Growth Rate of Real GDP

Stock Market Volatility

percent per year

Figure 3.4 Short- and Long-Term Interest Rates

currency per dollar

Figure 3.5: Daily Exchange Rates (Jan 3, 2000 - April 4, 2013)

DIFFERENCE EQUATIONS AND

Consider the function yt* = f(t*)

The key property of a solution is that it satisfies the

Given the value of y0, it follows that y1 will be given b

If | a1 | < 1, in the limit

Does it converge? Characteristic Roots

If a1 < 1, the yt converges to zero as t approaches infinity.

Generalizing the Method

A t a1A t-1 a2At-2 anA t-n = 0

yth = A1(1)t + A2(2)t +

At least one characteristic root equals unity if

The Solution Methodology

THE COBWEB MODEL

Setting supply equal to demand:

The homogeneous equation is pt = (/)pt1.

Stability requires | / | < 1

Consider the second-order equation

THE THREE CASES

WORKSHEET 1.1: SECOND-ORDER EQUATIONS

The homogeneous solution is: A1(0.7)t + A2(0.5)t.

The homogeneous solution is: A1(1.037)t + A2(0.337)t.

THE METHOD OF UNDETERMINED

The Method of Undetermined Coefficients

b0 + a0t + a1t1 + a2t2 + = a0 + a1[b0 + a0t1 + a1t2 + ] + t

The Method of Undetermined Coefficients II

Since we have a second-order equation, we use the challenge solution

[so that a1 = a1]

Lag Operators (contd)

Lag operators provide a concise notation for writing difference

yt = a0 + a1yt-1 + ... + apyt-p + t can be written as:

APPENDIX 1.1: IMAGINARY ROOTS

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