Time Series Econometrics

AR processes:

Suppose the value of a system today depends upon the value of the system in the previous

period multiplied by a constant (less than 1 in absolute value) in addition to white noise

shock that the system receives in the current period. In other words, suppose we have

Yt = α + β1Yt −1 + et 1)

where | β1 |< 1 and et : N (0, σ e ) is a serially uncorrelated process, meaning

2

E (et e j ) = 0 if i ≠ j .

Proposition 1:

α
E (Yt ) =
(1 − β )

Proof:

Yt = α + β1Yt −1 + et
= α + β1 (α + β1Yt −2 + et −1 ) + et
= α + αβ1 + β12Yt −2 + β1et −1 + et

Continuing in this fashion,

Yt = α + αβ +......... + αβj +... +e t + β1 e−t1 + β12 e−t2 +...... + βj

1 e −t j +...

which equals ( as j tends to infinity)

 α
Yt = + et + β1et −1 + .......+ β 1 jet − j + .... (2)
(1 − β1 )

Taking expectations of both the sides in equation 2 yields the proposition.

For simplicity, for the remainder of this note, let us set α = 0 .Proposition 1 then implies

E (Yt ) = 0 .

Proposition 2:

σ e2
Variance of Yt = σ Y =
2

(1 − β12 )

var iance(Yt ) = E (Yt 2 ) = σY2 = E ( β 12Yt 2−1) + E (et2 ) + 2 E (Yt −1et )

= β12σ Y2 + σ e2
∴
σ e2
σ = 2
Y
(1 − β12 )

Define γ 1 as E (YtYt −1 )

Proposition 3:

λ = β1σ e2 / (1 − β12 )

Proof:

E (YtYt −1 ) = β1 E (Yt −22 ) + E (Yt −1et )

∴
γ = β1σ Y2
= β1σ e2 / (1 − β12 )

Proposition 4:
E (YtYt − j ) = β1jσ e2 / (1 − β12 ) = γ j

Exercise: Prove Proposition 4.

Example: Suppose β1 = 0.7 and σ e = 1 . The following graph plots γ j as a function of

2

j=0,1,2,3,,,,,,,,,.

As you can see, the graph trends to zero as j becomes larger. This is referred to as the

autocorrelation function.

Exercise: Plot the autocorrelation function for an AR(1) process for β1 = −0.7 and σ e = 2 .
2

Proposition 6:

Define the correlation between Yt and Yt − j as ρ j .

ρ j = β1j

Prove proposition 6.

A plot of ρ j against j is referred to as the plot of the autocorrelation function.

Estimating the parameters of an AR(1) process:

Suppose we want to estimate the parameters α and β1 in the following AR(1) process:

Yt = α + β1Yt −1 + et where we have available to us T observations on Y.

Then,

T __ T −1
α ^ = ( ∑ Yt / T − 1) − β1^ ∑ Yt −1
t =2 t =1

 T  __
 __

 ∑  t t   t −1 t −1  
Y − Y Y − Y
β1^ =  t =2   
  T ___
 
2

 ∑  Yt −1 − Yt −1  
 t =2   

As you can see, this is just like estimating the parameters of a two variable regression, with

Yt −1 replacing X t . The standard errors of the coefficients can also be calculated in the same

way that you have done for two variable regression.

Forecasting from an AR(1) process:

Suppose we have the following AR(1) process:

Yt = α + β1Yt −1 + et

α
The unconditional forecast for Yt is simply its unconditional mean, (1 − β ) . The forecast
1

error for a one period ahead forecast is:

α α α
Yt +1 − = α + β1Yt + et +1 − = α + β1 (α + β1Yt −1 + et )+ et +1 −
(1 − β1 ) (1− β1 ) (1− β 1 )
If you keep on substituting for

α α α
Yt +1 − = α + β1Yt + et +1 − = α + β1 (α + β1Yt −1 + et ) + et +1 −
(1 − β1 ) (1 − β1 ) (1 − β1 )

Substituting for Yt − j , as j tends to infinity, we have

α α
et + β1et −1 + β12 et −2 + ......... + +
(1 − β1 ) (1 − β1 )
= et + β1et −1 + β12et −2 + .........

Therefore, the expected value of the forecast error is zero, indicating that using the

unconditional mean as a one period ahead forecast does indeed generate unbiased forecasts.

Exercise: Prove that the variance of the unconditional forecast is:

σ e2
(1 − β12 )

Conditional Forecasts:

The one period ahead conditional forecast for Yt +1 given Yt , E (Yt +1 | Yt ) = α + β 1 Yt

^ ^

The one period ahead forecast error is Yt +1 − α − β1Yt = et +1

The variance of one period ahead conditional forecast is σ e .This is more accurate than the
2

unconditional forecast, even though both are unbiased.

The two period ahead conditional forecast given Yt is α + β1 (α + β1Yt )

The error of two period ahead conditional forecast given Yt is given by e t +1 + β1et and the

variance of the forecast error is given by σ e (1 + β1 ) , i.e, the two period ahead conditional
2 2

forecast is less accurate than the one period ahead conditional forecast.

95% confidence intervals for a one period ahead conditional forecast when et is normally

distributed:

forecast +(-)1.96 σ e
^

95% confidence intervals for a two period ahead conditional forecast when et is normally

distributed:

forecast +(-)1.96 σ e (1 + β1 )
^ 2

The confidence interval for two period ahead forecast error is wider than that for one period

ahead forecast error.

Exercise: Show that as j tends to infinity, the j period ahead conditional forecast given Yt

converges to the unconditional forecast.

Exercise: Show that as j tends to infinity, the variance of the j period ahead forecast

converges to the variance of the error of the unconditional forecast.