WORKSHOP

on

Introductory
Econometrics with EViews
Asst. Prof. Dr. Kemal Bağzıbağlı
Department of Economic

Res. Asst. Pejman Bahramian

PhD Candidate, Department of Economic

Res. Asst. Gizem Uzuner

MSc Student, Department of Economic
EViews Workshop Series Agenda
1. Introductory Econometrics with EViews
2. Advanced Time Series Econometrics with EViews
a. Unit root test and cointegration
b. Vector Autoregressive (VAR) models
c. Structural Vector Autoregressive (SVAR) models
d. Vector Error Correction Models(VECM)
e. Autoregressive Distributed Lag processes
3. Forecasting, and Volatility Models with EViews
a. Forecasting
b. Volatility models
c. Regime Switching Models

2
Part 1 - Outline
1. Violation of Classical Linear Multiple Regression
(CLMR) Assumptions
a. Heteroskedasticity c. Model Misspecification
b. Multicollinearity d. Autocorrelation

2. “Stationarity is Job 1!”

3. Univariate Time Series Modelling

a. Autoregressive Integrated Moving Average (ARIMA) model

3
1. Violation of Classical
Linear Multiple
Regression (CLMR)
Assumptions
Multiple Regression Model

Deterministic components Stochastic component

● n observations on y and x:
● α & βi: unknown parameters

5
Assumptions
1) The error term (ut) is a random variable with E(ut )=0.
2) Common (constant) Variance. Var(ut ) = σ2 for all i.
3) Independence of ut and uj for all t.
4) Independence of xj
● ut and xj are independent for all t and j.
5) Normality
● ut are normally distributed for all t.
● In conjunction with assumptions 1, 2 and 3;
ut 〜 IN (0, σ2) 6
Violation of Basic Model Assumptions
HETEROSKEDASTICITY (nonconstant variance)
var(ut ) = E(ut2) = σ2 for all t (similar distribution)
Homoskedasticity:
● σ12 = σ22 = … = σ2n
● Constant dispersion of the
error terms around their
mean zero
7
Heteroskedasticity (cont.)
● Rapidly increasing or
decreasing dispersion
heteroskedasticity?
● Variances are different because
of changing dispersion
● σ12 ≠ σ22 ≠ ...≠ σ2n Var(ut )=
σt2
● One of the assumptions is
8
violated!
Heteroskedasticity (cont.)

Residuals increasing by x
heteroskedasticity?

9
Consequences of Heteroskedasticity
★ The ordinary least squares (OLS) estimators
are still unbiased but inefficient.
➢ Inefficiency: It is possible to find an alternative
unbiased linear estimator that has a lower variance
than the OLS estimator.

10
Consequences of Heteroskedasticity (cont.)
Effect on the Tests of Hypotheses
★ The estimated variances and covariances of the
OLS estimators are biased and inconsistent
➢ invalidating the tests of hypotheses (significance)
Effect on Forecasting
★ Forecasts based on the estimators will be unbiased
★ Estimators are inefficient
➢ forecasts will also be inefficient 11
Lagrange Multiplier (LM) Tests for
Heteroskedasticity
1. Park Test is a two-stage procedure
Stage 1:
● Run an OLS regression disregarding the
heteroskedasticity question.
● Obtain ut from this regression;

Stage 2:
● if β is statistically significant, there is heteroskedasticity.
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Park Test in EViews
ls compensation c productivity

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Park Test in EViews (cont.)

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Park Test in EViews (cont.)

u=0

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Park Test in EViews (cont.)
u2=u^2

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Park Test in EViews (cont.)
lnu2=log(u2) lnproductivity=log(productivity)

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Park Test in EViews (cont.)
● Probability value (p-value) of
lnproductivity (0.5257) is
greater than the critical value
of 0.05
● Statistically insignificant
homoskedasticity

18
Detection of Heteroskedasticity (cont.)
2. Glejser Test is similar in spirit to the Park test.
● Glejser (1969) suggested estimating regressions
of the type;
IûtI = α + βXt
IûtI = α + β/Xt
IûtI = α + β√Xt and so on
● Testing the hypothesis β=0 19
Glejser Test in EViews
genr au=@abs(u)

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Glejser Test in EViews (cont.)
ls au c productivity

Heteroskedasticity?

21
Glejser Test in EViews (cont.)
ls au c 1/productivity ls au c @sqrtproductivity

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Glejser Test in EViews (cont.)
ls compensation c productivity

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Glejser Test in EViews (cont.)

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Detection of Heteroskedasticity (cont.)
3. White’s Test
● Recommended over all the previous tests

Step 1: Obtain by OLS

Step 2: Compute the residual and square it

25
Detection of Heteroskedasticity (cont.)
3. White’s Test (cont.)
Step 3: Regress the squared residual against a
constant, X2t, X3t etc. (auxiliary equation)

Step 4: Compute the statistic nR2

● n: sample size, R2: unadjusted R2 from S.3
26
Detection of Heteroskedasticity (cont.)
3. White’s Test (cont.)
Step 5: Reject the null hypothesis that

● if
○ Upper a percent point on the chi-square dist. with 5 d.f.
● If the null hypothesis is not rejected
○ the residuals are homoskedastic
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White Test in EViews

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Solutions to the Heteroskedasticity Problem

➔ Taking the logarithm of Yt and Xt

◆ variance becomes smaller.

➔ Use the weighted least squares (WLS)

◆ Better than the first solution
◆ Guaranties homoskedasticity.
29
Solutions to the Heteroskedasticity Problem (cont.)

Graphical Method
● Check the residuals (i.e.
error variance)
○ linearly increasing with xt
● WLS

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Solutions to the Heteroskedasticity Problem (cont.)

● Not linearly but

quadratically increasing
error variance

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Solutions to the Heteroskedasticity Problem (cont.)

● Error variance decreasing

linearly

32
Applications with EViews
ls foodexp c totalexp foodexp c totalexp 01.makeresid u

33
Applications with EViews (cont.)
Command:
scat totalexp u

heteroskedasticity?

34
Applications with EViews (cont.)

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Applications with EViews (cont.)
lnfoodexp=log(foodexp) lntotalexp=log(totalexp)

36
Applications with EViews (cont.)
Command:
ls lnfoodexp c lntotalexp

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Applications with EViews (cont.)

38
Multicollinearity
OLS Ordinary Least Squares

BLUE classical normal linear

Independent variables in the regression

model are not correlated.
39
What is Multicollinearity?
● The problem of multicollinearity arises when
the explanatory variables have approximate
linear relationships.
○ i.e. explanatory variables move closely together
● In this situation, it would be difficult to isolate
the partial effect of a single variable. WHY?

40
Multicollinearity (cont.)
1. Exact (or Perfect) Multicollinearity
a. Linear relationship among the independent variables
2. Near Multicollinearity
a. Explanatory variables are approximately linearly
related
For example; If ➡ Exact
➡ Near
41
Theoretical Consequences of
Multicollinearity
Unbiasedness & Forecasts
★ OLS estimators are still BLUE and MLE and hence are
unbiased, efficient and consistent.
★ Forecasts are still unbiased and confidence intervals
are valid
★ Although the standard errors and t-statistics of
regression coefficients are numerically affected,
○ tests based on them are still valid

42
Theoretical Consequences of
Multicollinearity (cont.)
Standard Errors
★ Standard errors tend to be higher
○ making t-statistics lower
○ thus making coefficients less significant (and
possibly even insignificant)

43
Identifying Multicollinearity
● High R2 with low values for t-statistics
● High values for correlation coefficients
● Regression coefficients sensitive to specification
● Formal test for multicollinearity
○ Eigenvalues and condition index (CI)
k= max eigenvalues/min eigenvalues
CI=√k ➡ k is between 100 and 1000 ➡ multicollinearity?
High variance inflation factor (VIF)
➡ VIF>10 ➡ THEN multicollinearity is suspected.
44
Solutions to the Multicollinearity Problem

● Benign Neglect
○ Less interested in interpreting individual coefficients
but more interested in forecasting
● Eliminating Variables
○ The surest way to eliminate or reduce the effects of
multicollinearity

45
Solutions to the Multicol. Problem (cont.)

● Reformulating the Model

○ In many situations, respecifying the model can
reduce multicollinearity

46
Solutions to the Multicol. Problem (cont.)

● Using Extraneous Information

○ Often used in the estimation of demand functions
○ High correlation between time series data on real
income and the price level
■ Making the estimation of income and price elasticities
difficult
○ Estimate the income elasticity from cross-section
studies
■ and then use that information in the time series
model to estimate the price elasticity 47
Solutions to the Multicol. Problem (cont.)

● Increasing the Sample Size

○ reduces the adverse effects of multicollinearity
○ R2, including the new sample
■ goes down or remains approx. the same
● the variances of the coefficients will indeed decrease and
counteract the effects of multicollinearity

■ goes up substantially
● there may be no benefit to adding to the sample size 48
Applications with EViews
Overall statistically
significant

but one by one

statistically insignificant

multicollinearity
problem 49
Applications with EViews (cont.)
Command: eq01.varinf

50
Applications with EViews (cont.)

Command: scalar ci= @sqrt(66795998/3.44E-06)

CI: Condition Index

51
Applications with EViews (cont.)
The highest correlation
is between the price of
cars and the general
price level.

Even if we drop
these variables
one-by-one from
the model, still
we have a
multicollinearity
problem.
52
Applications with EViews (cont.)
● When we drop both the general price
level and the price of cars, the
multicollinearity problem is solved
○ but R2 is low.

● So we check the second highest

correlation between disposable
income and price level.

53
Applications with EViews (cont.)
DROP: General price level and
disposable income

After removing the variables, the

problem is solved.

Loss of valuable information?

It is better to try solving the

problem by increasing the sample
size
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Model Misspecification
1. Omitting Influential or Including Non-
Influential Explanatory Variables
2. Various Functional Forms
3. Measurement Errors
4. Tests for Misspecification
5. Approaches in Choosing an Appropriate
Model
55
The Ramsey RESET Test
RESET: Regression specification error test

Step 1: Estimate the model that you think is

correct and obtain the fitted values of Y, call them
Step 2: Estimate the model in Step 1 again, this
time include as additional explanatory
variables.
56
The Ramsey RESET Test (cont.)
Step 3: The model in Step 1 is the restricted model
and the model in Step 2 is the unrestricted model.
Calculate the F-statistic for these two models.
● i.e. carry out a Wald F-test for the omission of the
two new variables in Step 2
● If the null hypothesis
(H0: the new variables have no effect)
is rejected indication of a specification error 57
Autocorrelation
In the presence of autocorrelation, cov( ut,us )≠0 for
t≠s and the error for period t is correlated
with the error for period s.
●
● -1< ρ <1
○ ρ approaching 0 no correlation
○ ρ approaching +1 positive correlation
○ ρ approaching -1 negative correlation
58
Autocorrelation (cont.)

59
Causes of Autocorrelation

DIRECT INDIRECT

● Inertia or Persistence ● Omitted Variables

● Spatial Correlation ● Functional Form

● Cyclical Influences ● Seasonality

60
Consequences of Autocorrelation
● OLS estimates are still unbiased and consistent
● OLS estimates are inefficient not BLUE
○ Forecasts will also be inefficient
● The same as the case of ignoring heteroskedasticity
● Usual formulas give incorrect standard errors for OLS
estimates
● Confidence intervals and hypothesis tests based on the
usual standard errors are not valid
61
Detecting Autocorrelation
❖ Runs Test: Investigate the signs of the residuals. Are
they moving randomly? (+) and (-) comes randomly
don’t need to suspect autocorrelation problem.
❖ Durbin-Watson (DW) d Test: Ratio of the sum of
squared differences in successive residuals to the
residual sum of squares.
❖ Breusch-Godfrey LM Test: A more general test which
does not assume the disturbance to be AR(1).
62
Durbin-Watson d Test

STEP 1 Estimate the model by OLS and compute the

residuals ut
STEP 2 Compute the Durbin-Watson d statistic:

63
Durbin-Watson d Test (cont.)
STEP 3 Construct the table with the calculated DW
statistic and the dU, dL, 4-dU and 4-dL critical values.

STEP 4 Conclude
64
Resolving Autocorrelation
The Cochrane-Orcutt Iterative Procedure

Step 1: Estimate the regression and obtain residuals.

Step 2: Estimate the first-order serial correlation coefficient
(⍴) from regressing the residuals to its lagged terms.

Step 3: Transform the original variables as follows:

65
Resolving Autocorrelation (cont.)
Step 4: Run the regression again with the transformed
variables and obtain a new set of residuals.
Step 5 and on: Continue repeating Steps 2 to 4 for several
rounds until the following stopping rule applies:
● the estimates of ⍴ from two successive iterations differ by no
more than some preselected small value, such as 0.001.

66
Applications with EViews
Variables in natural logarith:
● LNCO: Copper price
● LNIN: Inudtrial production
● LNLON: London stock exchange
● LNHS: Housing price
● LNAL: Aluminium price

1.143 1.739

AUTOCORRELATION?
67
Applications with EViews (cont.)

H0: No autocorrelation

68
Applications with EViews (cont.)
To Fix it!

69
Applications with EViews (cont.)
To Fix it!
u=u(0)

70
Applications with EViews (cont.)
To Fix it!

Generate series:
● y= lnco-0.52*lnco(-1)
● x2= lnin-0.52*lnin(-1)
● x3= lnlon-0.52*lnlon(-1)
● x4= lnhs-0.52*lnhs(-1)
● x5= lnal-0.52*lnal(-1)
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Applications with EViews (cont.)
To Fix it!

1.124 1.743

Command:
ls y c x2 x3 x4 x5
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Applications with EViews (cont.)
To Fix it!

73
 Summary
Problem Source Detection
Heteroskedasticity Nonconstant variance Park Test, Glejser, White Test
Autocorrelation E(ut,ut-1)≠0 Durbin-Watson d Test, Run
Test, Breusch Godfrey LM Test
Multicollinearity Interdependence of xj ● High R2 but few significant
t ratios
● High pairwise correlation
between independent
variables
● Eigenvalues and condition
index, High VIF, Auxiliary
Regressions
Remedy
Taking logarithm,
Weighted least squares
Cochrane-Orcutt Iterative
Procedure and GLS
● Reformulating the
model
● Dropping variables,
● Additional new data
● Faitor analysis
● Principal comp.
analysis
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2. “Stationarity is Job 1!”
What is Stationarity?
● A stationary series can be defined as one with a
○ constant mean, constant variance and constant autocovariances
for each given lag.
● The mean and/or variance of nonstationary series are
time dependent.
● The correlation between a series and its lagged values
depend only on the length of the lag and not on when
the series started.
● A series that is integrated of order zero, i.e. I(0). 76
Example of a
white noise
process

Time series
plot of a
random walk
vs. a random
walk with drift
77
Example
PDI: Personal Disposable Income

78
What is Stationarity? (cont.)
● If a regression model is not stationary,
⇒ the usual “t-ratios” will not follow a t-distribution.
● The use of nonstationary data can lead to
spurious regressions.
● Results of the regression do not reflect the
real relationship except if these variables are
cointegrated.
79
3. Univariate Time Series
Modelling
Some Stochastic Processes
Random Walk

Moving Average Process

Autoregressive Process

Autoregressive Moving Average Process

81
Autoregressive Integrated MA Process
● Most time series are nonstationary
● Successive differencing stationarity
●
● : A stationary series that can be
expressed by an ARMA(p, q)
● can be represented by an ARIMA model
ARIMA(p, d, q)
82
Estimation and Forecasting with an
ARIMA Model
The Box and Jenkins (1970) Approach
● Identification
● Fitting (Estimation), usually OLS
● Diagnostics
● Refitting if necessary
● Forecasting

83
Identification
● The process of specifying the orders of differencing,
AR modeling, and MA modeling
● How do the data look like?
● What pattern do the data show?
- Are the data stationary?
- Specification of p, d, and q?
● Tools
- Plots of data
- Autocorrelation Function (ACF)
- Partial ACF (PACF) 84
Identification (cont.)
● To determine the value of p and q we use the graphical
properties of the autocorrelation function and the partial
autocorrelation function.
● Again recall the following:

85
 Model Fitting
● Model parameters are estimated by OLS
● Output includes
○ Parameter estimates
○ Test statistics
○ Goodness of fit measures
○ Residuals
○ Diagnostics
86
 Diagnostics
● Determines whether the model fits the data
adequately.
○ The aim is to extract all information and ensure that
residuals are white noise
● Key measures
○ ACF of residuals
○ PACF of residuals
○ Ljung-Box Pierce Q statistic 87
Preliminary Analysis with EViews
Select the series “dividends” in the workfile,
then select [Quick/Graph/Line graph]:

88
Preliminary Analysis with EViews (cont.)
[Quick/Generate Series]:

ddividends=d(dividends)
89
Preliminary Analysis: Identification
Correlogram
● The graph of autocorrelation function

against s, for s = 0, 1, 2, …, t-1

● Useful diagram for identifying patterns

in correlation among series.

● Useful guide for determining how

correlated the error term (ut ) is to the
past errors ut-1, ut-2, ...
90
Preliminary Analysis: Identification
Interpretation of Correlogram
● If ⍴ is high, correlogram for AR
(1) declines slowly over time
○ First differencing is indicated

91
Preliminary Analysis: Identification
Interpretation of Correlogram
● The function quickly decreases
to zero (a low ⍴)

92
Correlogram and Stationarity

93
Preliminary Analysis: Estimation
ARIMA(1,1,1)
Command: ls ddividens c AR(1) MA(1)

94
Empirical Example
Forecasting Monthly Electricity Sales

Total System Energy Demand

95
Empirical Example (cont.)
Forecasting Monthly Electricity Sales

Correlogram for Monthly Electricity Sales Data

96
Empirical Example (cont.)
Forecasting Monthly Electricity Sales
Correlogram for 12-Month Differenced Data
(Xt-Xt-12)

97
 Empirical Example (cont.)
Forecasting Monthly Electricity Sales

ARMA Order AIC RMSE

Box-Jenkins Forecast of System Energy
(1, 1) 1,930 320

(4, 1) 1,927 312

(1, 4) 1,926 311

(0, 4) 1,924 311

RMSE: Root mean squared error

Superior model:
ARIMA (0, 1, 4)
98
Bibliography
● Brooks, C. (2008) Introductory Econometrics for Finance,
● Gujarati D.N., Porter D.C. (2004), Basic Econometrics,The McGraw−Hill
Companies
● Maddala, G.S. (2002). Introduction to Econometrics.
● Ramanathan, R. (2002). Introductory econometrics with applications,
Thomson Learning. Mason, Ohio, USA.
● Wooldridge,J. (2000) Introductory Econometrics: A modern Approach.
South-Western College Publishing

99