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Auto Correlation

# Auto Correlation

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03/18/2014

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12 Autocorrelation
12.1 Motivation
\u2022Autocorrelation occurs when something that happens today has an impact on what
happens tomorrow, and perhaps even further into the future.

\u2022This is a phenomena that is mainly found in time-series applications.
\u2022Note: Autocorrelation can only happen into the past, not into the future.
\u2022Typically found in \ufb01nancial data, macro data, sometimes in wage data.

\u2022Autocorrelation occurs whencov(\ue000i ,\ue000j) \ue000= 0 \u2200i, j.
12.2
AR(1) Errors
\u2022AR(1) errors occur whenyi =Xi\u03b2 +\ue000i and
\ue000i= \u03c1\ue000i\u22121+ ui
where\u03c1 is the autocorrelation coe\ufb03cient,|\u03c1|< 1 andui\u223c N (0,\u03c32
u).
\u2022Note: In general we can have AR(p) errors which impliesp lagged terms in the error
structure, i.e.,
\ue000i= \u03c11\ue000i\u22121+ \u03c12\ue000i\u22122+\u00b7\u00b7\u00b7 + \u03c1p\ue000i\u2212p
\u2022Note: We will need |\u03c1|<1 for stability and stationarity. If |\u03c1|<1 happens to fail
then we have the following problems:
1.\u03c1 = 0: No serial correlation present
187
2.\u03c1 > 1: The process explodes

3.\u03c1 = 1: The process follows a random walk
4.\u03c1 =\u22121: The process is oscillatory
5.\u03c1 <\u22121: The process explodes in an oscillatory fashion

\u2022The consequences for OLS:\u02c6
\u03b2is unbiased and consistent but no longer e\ufb03cient and
usual statistical inference is rendered invalid.
\u2022Lemma:
\ue000i=
\u221e
\ue007
j=0
\u03c1j ui\u2212j
\u2022Proof:

\ue000i= \u03c1\ue000i\u22121+ ui
\ue000i\u22121= \u03c1\ue000i\u22122+ ui\u22121
\ue000i\u22122= \u03c1\ue000i\u22123+ ui\u22122

Thus, via substitution we obtain
\ue000i\u22121= \u03c1\ue000i\u22122+ ui\u22121
=\u03c1(\u03c1\ue000i\u22123 +ui\u22122) +ui\u22121
=\u03c12\ue000i\u22123 +\u03c1ui\u22122 +ui\u22121
and
\ue000i= \u03c1(\u03c12\ue000i\u22123+ \u03c1ui\u22122+ ui\u22121) + ui
=\u03c13\ue000i\u22123 +\u03c12ui\u22122 +\u03c1ui\u22121 +ui
188
If we continue to substitute for\ue000i\u2212k we get
\ue000i=
\u221e
\ue007
j=0
\u03c1j ui\u2212j
\u2022Note the expectation of\ue000i is
E[\ue000i] = E[
\u221e
\ue007
j=0
\u03c1j ui\u2212j]
=
\u221e
\ue007
j=0
\u03c1j E[ui\u2212j]
=
\u221e
\ue007
j=0
\u03c1j0 = 0
\u2022The variance of\ue000 is
var(\ue000i) = E[\ue0002i]
=E [(ui +\u03c1ui\u22121 +\u03c12ui\u22122 +\u00b7\u00b7\u00b7)2]
=E [u2i +\u03c1ui\u22121ui +\u03c12u2i\u22121 +\u03c14u2i\u22122 +\u00b7\u00b7\u00b7]
var(\ue000i) = \u03c32
u+\u03c12\u03c32
u+\u03c14\u03c32
u+\u00b7\u00b7\u00b7
\u2022Note:E[uiuj] = 0 for alli \ue000=j via the white noise assumption. Therefore, all terms
\u03c1Nwhere Nis odd are wiped out. This is not the same as E[\ue000i, \ue000j] = 0.
\u2022Therefore, thevar(\ue000i) is
var(\ue000i) = \u03c32
u+\u03c12\u03c32
u+\u03c14\u03c32
u+\u00b7\u00b7\u00b7
=\u03c32
u+\u03c12(var(\ue000i\u22121))
189