06/12/2017

Autocorrelation

ECN326: Basic Econometrics

Dr Arshad Ali Bhatti
Fall, 2017

Autocorrelation

That the error term from one time period

depends, in some systematic way, on error
terms from other time periods.
E(UtUt-1)≠0 for all t ≠ t-1
It is not the relationship b/w different
variables rather b/w the successive values of
the same variable.

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Reasons

Spatial Autocorrelation
Prolonged influence of shocks
Inertia (Tendency to remain unchanged)
Data manipulation
Misspecification

Consequences

If AC is ignored and OLS is used to estimate

the parameters then:
The estimates and forecasts will still be
unbiased and consistent.
The estimates and forecasts will be
inefficient.
The estimated variances of regression
coefficients will be biased, and hence tests
of hypotheses are invalid.

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Detection

Durbin-Watson d-test
Durbin-h
Artificial Regression

Durbin Watson d-Test

Limitations
Test is for first order serial correlation.
Test is inconclusive if the computed value of
d- statistic lies b/w dL and dU.
Test cannot be applied in models with lagged
dependent variables.

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Cont.

TEST statistic (d):

Σ tn= 2 (et − et −1 ) 2
d=
Σet2
d ≈ 2(1 − ρˆ )
Σe e
where ρˆ = t 2t −1
Σet

Cont.

How to check AC?

ρ^=0 suggests d=2 No AC
ρ^=1 suggests d=0 +ve AC
ρ^=-1 suggests d=4 -ve AC

When the calculated value of d-statistic is close to 2,

we accept the H0 of no AC.
When it is close to zero or 4, we reject H0.

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Durbin Watson d Statistic

Durbin h-statistic

Whenever one of the explanatory variable is the

lagged value of the dependent variable e.g. Yt-1, Yt-2
etc.

n
h = ρˆ
1 − n. var(bi )
where var(bi ) = Least square estimate of
the coefficient of lagged variable.
ρˆ = 1 − 0.5 d

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Cont.

h Statistic is normally distributed with mean

zero and variance of one.
If the p-value for h Statistic is low, we reject
H0 of NO Autocorrelation.

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Problem with h-statistic

When n{var(bi)} >1

i.e negative sign in the sq-root , h Statistic
cannot be calculated from the above formula.
One possible solution is to run the artificial
regression.

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Artificial Regression

Regress the LS residual et on et-1 plus all

the independent variables, including the
lagged dependent variable.
e.g.: Yt =b1 +b2 X2t + b3 Yt-1+ et (Actual Reg.)
et =α1 + α2 et-1+ α3 X2t + α4 Yt-1+ vt
(Artificial Regression)
Test H0: No AC,
by the significance of the coefficient of et-1
using t-test.

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Solutions

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Generalized Least Square (GLS)

Theory:
Say the original model is:
Yt = β1+ β2 X2t + ut
with first-order autoregressive specification on Ut.
i.e.

u t = ρ u t −1 + vt where − 1 ≤ ρ ≤ +1

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Cont.

Steps:
Transform the model with the autoregressive
disturbance term in to a model with a non-
autoregressive disturbance term.
That is Yt*= Yt - ρ^Yt-1 and X2t*=X2t-ρ^X2t-1
Regress Y* on X* using OLS
The GLS estimates from this transformed
model are efficient and consistent.

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Applications:

In practice we add AR(1) specification as an

explanatory variable in to the actual model
and re-estimate it……. d Statistic is likely to
improve unless there is any other problem
like non-stationarity etc.
Discuss Interest rate model (EX47 Pindyck)
Discuss dynamic consumption function (data
Ex67) and use Durbin h Statistic to check AC.

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References:

Gujrati D. N., Basic Econometrics, 4th ed., McGraw

Hill.
Kennedy Peter, A Guide to Econometrics, 4th ed.,
McGraw Hill.
Pindyck & Rubinfeld, Econometric Models and
Economic Forecasts, 4th ed., McGraw Hill.
Thomas R.L., Introductory Econometrics, 2nd ed.,
Longman.
Johnson & Johnson, Basic and Applied
Econometrics, MacMillan.

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