Questions and Answers on Regression Models with Lagged Dependent Variables and ARMA models

L. Magee 1. Consider an AR(1) process: all t = s. Assume that and

ts , t t

Winter, 2012

t1

2 + ut , where E(ut ) = 0, E(u2 ) = u , and E(ut us ) = 0 for t ts ),

is stationary. Derive a formula for Cov( t ,

the covariance of

that holds for s = 0, 1, 2, 3, . . ..

2. Let ut be white noise. That is, E(ut ) = 0 E(u2 ) t =

2

for all t for all t for all t and s where s = 0

E(ut uts ) = 0

2 For each of the following time series processes, determine the variance of yt as a function of u

and of parameters appearing in the equations below. Also derive the rst- and second-order autocovariances and autocorrelations. Assume that the time series processes are stationary. (a) yt = yt1 + ut (b) yt = + t , (yt is an AR(1) process)
t

where

t1

+ ut

is an AR(1) process)

(c) yt = ut + ut1

(yt is an MA(1) process) (yt is an MA(3) process)

(d) yt = ut + 0.6ut1 + 0.2ut2 + 0.1ut3 3. Consider a stationary AR(2) process yt = + 1 yt1 + 2 yt2 + ut

where 2 = 0. Are there values of 1 and 2 for which this process could be re-written in moving average form as an MA(2) process? If so, what are the values of 1 and 2 ? If no such values exist, briey explain why not. 4. An autoregressive distributed lag model is estimated as: yt = 31.2 + 0.61yt1 + 0.19yt2 + 1.40xt + 0.58xt1 + ut Consider the eect on y of a one-unit increase in x at time t in the following two cases:

(a) x remains one unit higher permanently after time t . (b) x immediately returns to its former level at time t + 1. Obtain the estimated eect on y in each of these cases at the four time periods: t , t + 1, t + 2, and the long run eect, t + . 5. Consider a regression model with a constant term and three explanatory variables, which include the lagged dependent variable yt1 and two other variables, x1t and x2t . The estimated model is yt = 21.0 + 0.6yt1 + 1.5x1t + 0.75x2t + et (a) Obtain the estimated eect on y of a permanent one-unit increase in x1 at time t (that is, x1 remains one unit higher permanently after time t ) at the four time periods: t ; t + 1; t + 2; and the long run eect, t + . (b) Compare the size of the estimated eect on y of a permanent one-unit increase in x1 to the size of the estimated eect on y of a permanent one-unit increase in x2 . Mention their initial (time t ) eects and their long run eects. No algebra or calculations are required. 6. For each of the following time series processes (a) yt = + yt1 + ut (b) yt = + ut + 0.6ut1 + 0.2ut2 derive (i) the unconditional mean, E(yt ) (ii) the unconditional variance, Var(yt ) (iii) the rst-order autocovariance, Cov(yt , yt1 ) = E(yt E(yt ))(yt1 E(yt1 )) Assume: E(ut ) = 0 for all t; E(u2 ) = 2 for all t; E(ut uts ) = 0 for all t and s where s = 0; and t that the time series processes are stationary. 7. An autoregressive distributed lag model is estimated as yt = 11 + 0.7yt1 0.4yt2 + 9xt + 2xt1 + ut Consider the eect on y of a one-unit increase in x at time t where x remains one unit higher permanently after time t . Obtain the estimated eect on y at time t , t + 1, t + 2, and the long run eect.

8. Consider a regression model with a constant term and three explanatory variables, which include the lagged dependent variable yt1 and two other variables, x1t and x2t . The estimated model is yt = 2.1 + 0.8yt1 2.0x1t + 0.5x2t + et (a) Obtain the estimated eect on y of a permanent one-unit increase in x1 at time t (that is, x1 remains one unit higher permanently after time t ) at the four time periods: t ; t + 1; t + 2; and the long run eect, t + . (b) Compare the size of the estimated eect on y of a permanent one-unit increase in x1 with the size of the estimated eect on y of a permanent one-unit increase in x2 . Mention their initial (time t ) eects and their long run eects. No algebra or calculations are required. 9. Suppose
t t

follows a stationary AR(1) process:

t1

+ ut ,

t = 1, . . . , n

where ut is white noise. Let = 0.6 and Var(ut ) = 5. (a) Obtain the numerical value of the correlation between (b) Obtain the numerical value of Var( t ) (c) Suppose that E(ut ) = 10, instead of the usual zero-mean assumption. What is the numerical value of E( t )? 10. Let ut be white noise, where E(ut ) = 0 for all t
t

and

t3

E(u2 ) = 20 for all t t E(ut uts ) = 0 for all t and s where s = 0

Let yt = ut + 0.7ut1 + 0.1ut2 . Determine the numerical values of (a) Var(yt ) (b) The correlation between yt and yt1 (c) The covariance between yt and yt1 Answers 1. (1 L)
t

= ut

= (1 L)1 ut
t

= ut + ut1 + 2 ut2 + . . .

Since E( t ) = 0 for all t, then Cov( t ,

ts )

= E(

t ts )

= E(ut + ut1 + 2 ut2 + . . . + s uts + . . .) (uts + uts1 + 2 uts2 + . . .) Because (Eut us ) = 0 for all t = s, the only terms with non-zero expectations in this product are those with equal subscripts on the us. Then the above expression simplies to Cov( t ,
ts ) s+4 2 = E(s u2 + s+2 u2 uts2 + . . .) ts ts1 + 2 2 2 = s (u + 2 u + 4 u + . . .) 2 = s u (1 + 2 + 4 + . . .) s = 2 , for all s = 0, 1, 2, . . . (1 2 ) u

2. (a) Var(yt ) = Var(yt1 + ut )

2 = 2 Var(yt1 ) + u 2 = 2 Var(yt ) + u 2 so Var(yt ) = u /(1 2 )

Cov(yt , yt1 ) = E(yt yt1 ) (since Eyt = 0)

2 = E(yt1 + ut )yt1 = E(yt1 ) = Var(yt )

For Cov(yt , yt2 ), use: yt = yt1 + ut = (yt2 + ut1 ) + ut = 2 yt2 + ut1 + ut Then Cov(yt , yt2 ) = E(yt yt2 ) = E( 2 yt2 + ut1 + ut )yt2
2 = 2 E(yt2 ) = 2 Var(yt )

Substitutions then give: Corr(yt , yt1 ) = Cov(yt , yt1 ) Var(yt )Var(yt1 ) =

and similarly Corr(yt , yt2 ) = 2

(b) (yt ) =

t1

+ ut

= (yt1 ) + ut This is like (a) except now E(yt ) = instead of = 0 and we now have replacing part (a)s . Then
2 Var(yt ) = u /(1 2 )

Cov(yt , yt1 ) = E(yt )(yt1 ) = Var(yt ) Cov(yt , yt2 ) = 2 Var(yt ) Corr(yt , yt1 ) = Corr(yt , yt2 ) = 2
2 2 2 (c) Var(yt ) = Var(ut + ut1 ) = Var(ut ) + 2 Var(ut1 ) = u + 2 u = (1 + 2 )u 2 Cov(yt , yt1 ) = E(ut + ut1 )(ut1 + ut2 ) = E(u2 ) = u t1

Cov(yt , yt2 ) = 0 (yt and yt2 have no ut s in common and the ut s are not correlated) Corr(yt , yt1 ) =
2 u = 2 ) 2 (1 + u 1 + 2

Corr(yt , yt2 ) = 0
2 2 2 2 (d) Var(yt ) = u + (0.6)2 u + (0.2)2 u + (0.1)2 u 2 = (1 + 0.36 + 0.04 + 0.01)u 2 = 1.41u

Cov(yt , yt1 ) = E(ut + 0.6ut1 + 0.2ut2 + 0.1ut3 )(ut1 + 0.6ut2 + 0.2ut3 + 0.1ut4 )
2 2 2 = 0.6u + 0.12u + 0.02u 2 = 0.74u

Cov(yt , yt2 ) = E(ut + 0.6ut1 + 0.2ut2 + 0.1ut3 )(ut2 + 0.6ut3 + 0.2ut4 + 0.1ut5 )
2 2 = 0.2u + 0.06u 2 = 0.26u

Corr(yt , yt1 ) =

0.74 = 0.52 1.41 0.26 Corr(yt , yt2 ) = = 0.18 1.41

3. Write this process as (1 1 L 2 L2 )yt = + ut Invert the lag polynomial to get it in MA form yt = (1 1 L 2 L2 )1 ( + ut ) = /(1 1 2 ) + (1 1 L 2 L2 )1 ut The inverse lag polynomial (1 1 L 2 L2 )1 is an innite series of the form 1 + 1 L + 2 L2 + 3 L3 + . . ., which is an innite-order MA, not an MA(2). One way to see this is to factor the original quadratic lag polynomial as (1 1 L)(1 2 L) for some 1 and 2 values. 1 and 2 both are non-zero since 2 = 0. The inverse of this factorized lag polynomial is the product of two innite-term geometric series (1 1 L)1 (1 2 L)1 = (1 + 1 L + 2 L2 + 3 L3 + . . .)(1 + 2 L + 2 L2 + 3 L3 + . . .) 1 1 2 2 which itself is an innite series. 4. In this answer, yt +2 does not have the usual rst-dierence-over-time meaning. Interpret the symbol as the dierence between y with and without the change in x. For example, yt +2 = (yt +2 when x changes as described) (yt +2 when x does not change as described). (a) yt = 1.40xt = 1.40(1) = 1.40 yt +1 = 0.61yt + 1.40xt +1 + 0.58xt = 0.61(1.40) + 1.40(1) + 0.58(1) = 2.834 yt +2 = 0.61yt +1 + 0.19yt + 1.40xt +2 + 0.58xt +1 = 0.61(2.834) + 0.19(1.40) + 1.40(1) + 0.58(1) = 3.975 The permanent eect can be obtained from y = 0.61y + 0.19y + 1.40x + 0.58x, where x is the permanent change in x. Then solve for y: (1 0.61 0.19)y = 1.98x y = 1.98 x = 9.9x = 9.90 0.2

(b)

yt = 1.40xt = 1.40 yt +1 = 0.61yt + 0.58xt = 0.61(1.40) + 0.58(1) = 1.434 yt +2 = 0.61yt +1 + 0.19yt = 0.61(1.434) + 0.19(1.40) = 1.141 The permanent eect is y = 0 since the permanent change in x is x = 0. (Now xt +1 = 0)

5. (a) Eect at time t : 1.5 at time t +1 : 1.5 + 0.6 1.5 = 2.4 at time t +2 : 2.4 + (0.6)2 1.5 = 2.94 at time t + : 1.5/(1 .6) = 3.75 (b) At every time period, the eects of x2 on y are half as big as the eects of x1 on y. Reason: The coecient on x2 is half the size of the coecient on x1 , and the dynamic pattern of the eects is the same for both, because that depends only on the coecient on yt1 . 6. (a) (i) Eyt = + Eyt1 + Eut = Eyt = + Eyt = (Eyt )(1 ) = = Eyt = /(1 ) (ii) Var(yt ) = 2 Var(yt1 ) + Var(ut ) = Var(yt ) = 2 Var(y) + 2 = Var(y) = 2 /(1 2 ) (iii) yt Eyt = + yt1 + ut E( + yt1 + ut ) = + yt1 + ut ( + Eyt1 ) = (yt1 Eyt1 ) + ut So E(yt Eyt )(yt1 E(yt1 )) = E((yt1 Eyt1 ) + ut )(yt1 Eyt1 ) = E(yt1 Eyt1 )2 = Var(yt ) (b) (i) Eyt = (ii) Var(y) = E(yt )2 = (1 + .62 + .22 ) 2 = 1.4 2 (iii) E(yt Eyt )(yt1 E(yt1 )) = E(ut + .6ut1 + .2ut2 )(ut1 + .6ut2 + .2ut3 ) = .6Eu2 + .12Eu2 = .72 2 t1 t2 7. at t y = 9 1 = 9 at t + 1, y = 0.7 9 + 9 1 + 2 1 = 17.3 at t + 2, y = 0.7 17.3 0.4 9 + 9 1 + 2 1 = 19.51 long run eect is y =
9+2 1.7+.4

11 0.7

= 15.71

8. (a) Eect at time t : 2.0 at time t +1 : 2.0 + 0.8 (2.0) = 3.6 at time t +2 : 2.0 + 0.8 (3.6) = 4.88 at time t + : 2.0/(1 .8) = 10.0 (b) At every time period, the eect of a change in x2 on y is 0.25 times the eect of a change in x1 on y. This is because the coecient on x2 is 0.25 times the coecient on x1 . This ratio does not change over time, because the way that the eect changes over time in this model depends only on the coecient on yt1 . 9. (a) When
t

follows a stationary AR(1) process with rst-order autocorrelation coecient ,

ts )

then corr( t ,

= s . Therefore corr( t ,
t1 )

t3 )

= 3 = (0.6)3 = 0.216

(b) Var( t ) = 2 Var( Var( t ) =

5 10.36

+ Var(ut )

Var( t ) = 0.36Var( t ) + 5 = 7.81 + E(ut ) (c) E( t ) = E( E( t ) = 10. (a) Var(yt ) = Var(ut ) + (.7)2 Var(ut1 ) + (.1)2 Var(ut2 ) = 20 + .49(20) + (.01)20 = 20(1 + .5) = 30 (b) Since E(yt ) = 0, then cov(yt , yt1 ) = E(yt yt1 ) = E(ut + .7ut1 + .1ut2 )(ut1 + .7ut2 + .1ut3 ) = .7E(u2 ) + (.7)(.1)E(u2 ) t1 t2 = (.7 + .07)20 = 15.4 (c) corr(yt , yt1 ) = = cov(yt , yt1 ) Var(yt )Var(yt1 ) 15.4 = .513 30 30
10 10.6 t1 )

E( t ) = 0.6E( t ) + 10 = 25