Autocorrelation

There is serial correlation (i.e. autocorrelation) when either the dependent variable (AR models) or the residual (MA morels) show correlation with its values in pasts periods. This is a problem because standard errors (even heteroskedastic robusts) are not

concistent, affecting statistical inferences (i.e. hypothesis testing). In cross section data, it is relatively safe to assume

E(ei,ej)=0

In words, the residuals are completely independent across observations. However, it is usually the case that errors are not independent in time series. Observations for the same individual in different periods of time are usually correlated. There are many factors that may cause this (auto)correlation:

a) Cyclical components b) Ommited variable bias c) Functional form misspecification d) Data manipulation: secondary effect of smooting or interpolation techniques in copiling statistics

Consider the simplest bivariate model y t = 0 + 1 x t + et

where the residuals et follow a first order autoregression process et = et 1 + u t

and u t is an error term with no serial correlation. The parameter is the correlation coefficient and indicates how strong the autocorrelation is. Replacing iteratively r times, the residuals can be expressed as e geometric series of the error terms u t .

et = u t + u t 1 + 2 u t 2 + ... + r u t r + r +1et r +1 = i u t i + r +1et r +1

i=0

Since 1 < < 1 and r +1et r +1 tend to zero, the last term can be dropped as r

et = i u t i
i =0

where

E (et ) = E ( i u t i ) = i E (u t i ) = 0
i=0 i =0

and

u2 V (et ) = V ( u t i ) = ( ) V ((u t i ) ) = 1 2 i=0 i =0

i i 2 2

The last result for the variance of the residuals assume u t is homoskedastic.

The OLS estimator 1 is unbiased and consistent but the usual standard errors are not. The variance of beta looks like

V ( 1 ) =

( xi x )( x j x ) k 1 + 2 ( xt x ) 2 ( xi x )

u2

Which is clearly no the simplest variance case for homoskedastic errors. It is very likely that the standard errors are underestimated which will lead to the usual t and F statistic not to be valid.

Detecting Autocorrelation in the Error Term

Since the true population errors are not observed, all autocorrelation detection procedures are based on regression residuals which are the sample estimates of the population error terms. The first method relies on graphical detection. This method is very important and should be always consider the initial detection step. You run the regression and obtain the residuals which should be plotted over time. We work with the workfile sugar.wf1 (which is part of the data sets provided by Hill, Griffiths and Judge, 2002) and estimate ln( At ) = 0 + 1 ln( Pt ) + et . Figure 1 presets the graphs of the residuals (levels and first difference). The general pattern of the residuals reflects some inertia where positive (negative) errors are followed by positive errors (negative)

Method 2: Durbin Watson Test:

Then, you have more formal tests. The most commonly used is the Durbin-Watson test and it is based on simulations of the AR(1) model for the error term et . Notice that this is different to the AR(1) model for the dependent variable. Stock and Watson mostly work with this second case while here we introduce the AR(1) model to the binary regression analysis. Consider a regression model with two equations: y t = 0 + 1 x t + et et = et 1 + u t

This is a two-sided sided test of no serial correlation ( H 0 : e = 0 , H 1 : e 0 ). E-views automatically produce the Durbin Watson (d) statistic which is reported on the regression output. Consider, again, ln( At ) = 0 + 1 ln( Pt ) + et

Dependent Variable: LOG(A) Method: Least Squares Date: 12/04/08 Time: 23:58 Sample: 1 34 Included observations: 34 Variable C LOG(P) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Coefficient 6.111328 0.970582 0.706345 0.697168 0.308771 3.050865 -7.258010 1.291242 Std. Error 0.168570 0.110629 t-Statistic 36.25397 8.773336 Prob. 0.0000 0.0000 4.707273 0.561094 0.544589 0.634375 76.97143 0.000000

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

You can find the d-statistic on the botton left-hand corner of the regression output. This statistics is defined as:
d = 2(1 )

Therefore, no serial correlation is consistent with a d-statistic close to 2. When d = 2 , the

correlation coefficient is zero and there is no evidence of autocorrelation in the error term.. If d < 2 ( d > 2 ), there is evidence of positive (negative) autocorrelation. There is perfect positive (negative) autocorrelation when d = 0 ( d = 4 ). E-views does not provide tables for the critical values or p values of the Durbin-Watson test. In our case, the d-statistic is 1.29, situated in the rejection area1. You will not be

required to do hypothesis testing with the d-w statistic but you need to know what it is for.

Go to http://www.stanford.edu/~clint/bench/dwcrit.htm. For T=34 and 2 parameters, you have two critical values for 5% significance level 1.39 (lower level) and 1.51 (upper level). A d statistic below 1.39 is strong evidence of positive serial correlation while you do not reject the null of no correlation if the d statistic is above the upper level (1.51). Values in the interval are mixed evidence so it is inconclusive.

Method 3: LM Test.

Durbin-Watson is, together with AFD unit root test, the most commonly used test in time series. However, it is import to know that it is not relevant in many instances, for instance if the error distribution is not normal, or if you have the dependent variable in a lagged form as an independent variable this is not an appropriate test for autocorrelation. A test that is suggested that does not have these limitations is the Lagrange Multiplier test for autocorrelation or Breusch-Godfrey test. Starting from the initial equation yt = 0 + 1 xt + et , the perturbation term et is estimated and its first lag introduced in an auxiliary regression. The t-statistic of the new variable gives you . Eviews compute this statistic directly from the equation window, clicking on

View/Residual Tests/SerialCorrelation LM Test. You should indicate the number of

lagged residuals to be included (in this cse, only one). The final outpt should be similar to:

Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 4.022271 3.904864 Probability Probability 0.053699 0.048147

Test Equation: Dependent Variable: RESID Method: Least Squares Date: 12/05/08 Time: 01:58 Variable C LOG(P) RESID(-1) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Coefficient 0.019701 0.011818 0.343298 0.114849 0.057742 0.295148 2.700477 -5.184062 1.978183 Std. Error 0.161432 0.105912 0.171173 t-Statistic 0.122040 0.111581 2.005560 Prob. 0.9037 0.9119 0.0537 1.01E-16 0.304057 0.481415 0.616094 2.011135 0.150928

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Since the p-val is higher than 5% but below 10%, the rejection or no rejection of the null hypothesis of no serial correlation depends on the significance level selected. At 5%, we can not reject the hypothesis that there is no autocorrelation. This result contradict our

conclusion from the d-statistics. However, take into account we can reject no serial correlation at 10% significance level. One advantage of this test is that can be generalized to higher order of autocorrelation. You should introduce further lags of the estimated residuals and use the F-statistic to thest the null hypothesis of no serial correlation.

Figure 1: Residual Plot

Equation _reg01.ls LOG(A) C LOG(P) warning: this is time series so no heterosk. robust se. line resid line d(resid)
0.8
0.8 0.6 0.4 0.2 0.0 -0.2

0.6 0.4 0.2 0.0 -0.2

-0.4 -0.6 -0.8 5 10 15 20 RESID 25 30

-0.4 -0.6 5 10 15 20 D(RESID) 25 30

The residual line plot shows some positive correlation while the first difference shows negative correlation.

Code: E-views code for serial correlation

This is the Durbin-Watson statistic Equation _reg01.ls LOG(A) C LOG(P) Scalar d-stat=@dw

Lagrange Multiplier test Equation _reg01.ls LOG(A) C LOG(P) Genr ehat=resid Equation _reg01.ls LOG(A) C LOG(P) ehat(-1)