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Jamie Monogan
University of Georgia
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 1 / 20
Objectives
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 2 / 20
Long and Short Rates Again
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 3 / 20
Long and Short Rates Again
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 4 / 20
Long and Short Rates Again
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 5 / 20
Long and Short Rates Again
Targeting
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Long and Short Rates Again
Example
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Long and Short Rates Again
Intuition
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Cointegration Models
Cointegration
Engle and Granger 1987
Interpretation
Coefficient on ∆xt will tap Granger causality.
A negative coefficient on zt−1 will be error correction.
Either is indicative of causality.
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 11 / 20
Cointegration Models Engle-Granger Two-Step
Software
R
model.1 < −lm(y∼x)
model.1$residuals
adf.test(model.1$residuals, k=0) (to demonstrate no unit root)
model.2 < −lm(d.y∼d.x+l.z, data=yourCreation) (You must take
differences and lags, then put them in a ts.union)
Stata
reg y x
predict z,r
dfuller z (to demonstrate no unit root)
reg d.y d.x l.z
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 12 / 20
Cointegration Models Single Equation Error Correction
Estimate:
∆yt = β0 + β1 yt−1 + β2 xt−1 + β3 ∆xt + et
Notice that x appears both as a level, xt−1 , and as a first difference,
∆xt
rearrange:
∆yt = β0 + β3 ∆xt + β1 yt−1 + β2 xt−1 + et
∆yt = β0 + β3 ∆xt + β1 (yt−1 + (β2 /β1 )xt−1 ) + et
Changing notation, β3 = α and π = β1 , we are back to the E/G
two-step model. (Though our coefficient on xt will be transformed.)
∆yt = β0 +α ∆xt + πzt−1 +et
From DL to ADL
yt = α0 + α1 yt−1 + β0 xt + et (1)
and adds a term for xt−1 .
Since yt = f(xt ), adding the t-1 term simply relaxes assumptions
about how x influences y dynamically. So the ADL(1,1) is appropriate
wherever LDV is appropriate.
R
lm(d.y∼l.y+l.x+d.x, data=yourCreation)
This assumes you have created a ts.union with differences and lags.
Stata
reg d.y l.y x d.x
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 15 / 20
Error Correction for Stationary Series: From ADL to ECM Derivation
yt = α0 + α1 yt−1 + β0 xt + β1 xt−1 + et .
3 Then add β0 xt−1 and −β0 xt−1 to the right hand side:
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 16 / 20
Error Correction for Stationary Series: From ADL to ECM Derivation
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 17 / 20
Error Correction for Stationary Series: From ADL to ECM Derivation
Recommended Reading
Do This Wrong and You Could Report Spurious Results
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Other Approaches
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Homework
Examine the data on short and long term interest rates (RATES.DTA).
For this exercise, consider a one-way ECM in which treasury bonds
(long-term interest rates, tbonds) are a function of prime rates
(short-term interest rates, prime).
Follow the two-step procedure for estimating an error correction
model:
Are the separate series integrated?
What is the result of the cointegrating regression?
Are the residuals stationary?
What is the result of your second-step error correction model?
Estimate a single-equation error correction model as well.
For your own papers: Present a table of a preliminary model.
Reading: Event History Modeling, Chapters 1-4.
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 20 / 20