Introduction to Econometrics

Lecture 9
More on Dynamic Models
Modelling Strategies

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Guy Judge April 2007

Dynamic model formulations

Simple delayed effects models

Distributed lag models and the Koyck
transformation
A review of the Partial Adjustment Mechanism
Autoregressive models
Autoregressive Distributed Lag (ADL) models
Error Correction models (ECM)

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Guy Judge April 2007

Simple delayed effect models

Yt = a + b Xt-1 + ut
Changes in X affect Y but with a known lag (in this case one period).
Provided the length of the lag is known, or is easily established, this raises no new
problems. Indeed it can be helpful from a forecasting point of view because the
value of the independent variable will be known with certainty at the time when the
next forecast of Y is to be made.
EXAMPLE: Forecasting employment in Orange County (California)
EMPt = a + b RGNPt + ut
where EMPt denotes total employment in the county in quarter t,
RGNPt-1denotes real GNP for the whole of the US in the previous quarter.
Source: Doti and Adibi (1998)
Here we can actually exploit the lags in the relationship for forecasting purposes

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Guy Judge April 2007

Distributed lag models

Yt = a + b0Xt + b1 Xt-1 +.+ bsXt-s+ ut
where s is the maximum lag allowed for.
Rather than assume that the whole of the affect is delayed, this model has the effect
distributed over a number of periods.
Problems:
establishing the maximum lag s
loss of degrees of freedom
possible multicollinearity
Example. Accidents and safety training; Koop (2000)
Yt = a + b0Xt + b1 Xt-1 +..+ b4Xt-4+ ut
where Yt = losses due to accidents for a company (/month)
Xt = hours of safety training provided to each worker in month t
A simple regression of Y on X appeared to show no relationship between these
variables - although the DW stat suggested misspecification.
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Guy Judge April 2007

The Koyck transformation

Suppose that we anticipate a gradual decline in the affect of X on Y as the number of periods
increase. For example Y might be sales and X advertising expenditure. If we can assume a
geometric rate of decline and an infinite lag structure we can use the Koyck transformation to
produce a simple model with just Xt and Yt-1 as regressors
Writing Yt = a + b0Xt + b1 Xt-1 +.+ bsXt-s +..+ ut

[1]

If bj+1/bj = for all j (with b0 just = b)

[1] becomes
Yt = a + bXt + bXt-1 +.+ sbXt-s + ....+ ut

[2]

Lag [2] by one period and multiply by

Yt-1 = a + bXt-1+ 2bXt-2 +.+ sbXt-s + .+ ut

[3]

Subtract [3] from [2] and rearrange

Yt = a(1- ) + bXt + Yt-1 + ut - ut-1
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[4]
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A review of the partial adjustment model

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A review of the partial adjustment model (2)

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The underlying rationale of the partial adjustment model

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The underlying rationale of the partial adjustment model ( 2)

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The Error Correction Mechanism (ECM)

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The simple ECM specification a consumption function

example

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Autoregressive-distributed lag models

(ARDL models)

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An example of an AR model in economics

Robert E Hall (JPE 1978) suggested that consumption would follow a simple first-order
autoregressive process if
(1) consumption depends only upon permanent income (YP)
(2) agents expectations are formed rationally
The second assumption means that YPt = YPt-1 + t where E(t) = 0
t represents the revision made to agents perceived permanent income in period t.
Individuals out not to expect their permanent income to change if they did this knowledge
should already have been used to reassess permanent income so Halls consumption
function is sometimes known as the surprise consumption function t is the surprise.
(1) requires Ct = K YPt
Substituting we find that
Ct = Ct-1 + K t
or Ct = Ct-1 + t
Consumption should follow a random walk.
The model is easily testable against less restricted models and is typically rejected.

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Modelling strategies
The three golden rules of econometrics are
test, test and test. David F. Hendry (1980)

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General to specific modelling

Begin with a general model which nests
the restricted model and so allows any
restrictions to be tested
These restrictions may be suggested
either by theory or by empirical results

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Guy Judge April 2007

General to specific modelling (2)

diagnostic testing of the general model
TEST 1
First ensure that the general model does not
suffer from any diagnostic problems. Examine
the residuals in the general model to ensure that
they possess acceptable properties.
(Test for problems of autocorrelation,
heteroskedasticity, non-normality, incorrect
functional form etc.)
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Guy Judge April 2007

General to specific modelling (3)

General
to specific
testing
restrictions
on the modelling
general model

TEST 2
Now test the restrictions implied by the
specific model against the general model
either by exclusion tests or other tests of
linear restrictions.

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Guy Judge April 2007

General to specific modelling (4)

General testing
to specific
diagnostic
of the modelling
simple model

TEST 3
If the restricted model is accepted, test its
residuals to ensure that this more specific
model is still acceptable on diagnostic
grounds

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Guy Judge April 2007

General to specific modelling (5)

the two blades of the scissors
Test parameter restrictions
on the more general model
Then check diagnostics for
the restricted model

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Guy Judge April 2007

Frequently (and recently) asked questions!

Should I include all the variables in the

database in my model?
How many explanatory variables do I need in
my model?
How many models do I need to estimate?
What functional form should I be using?
Do I need to include lagged variables?
What are interactive dummies do I need
them?
Which regression model will work best and how
do I arrive at it?
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Guy Judge April 2007

Typical cross-section model

Maybe several hundred observations

Maybe 10-12 potential explanatory variables, some of which will
be dummy variables.
So plenty of degrees of freedom but still lots of potential models
to try, especially if you consider alternative functional forms,
interactive dummies
Maybe problems of multicollinearity, heteroskedasticity and nonnormality
Model selection is not just a matter of maximizing Rbar-squared
over all possible models (or some other criterion)
Use economic theory and past studies to identify core variables
Test exclusion restrictions from a general model but balanced
against misspecification tests. Informed searches.

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Guy Judge April 2007

Typical time series model

Maybe only around a hundred observations

Maybe four or five potential explanatory variables, some of which
may be dummy variables.
Relatively few degrees of freedom but still lots of potential models to
try, especially if you consider alternative functional forms, lagged
variables and interactive dummies
As well as problems of multicollinearity, heteroskedasticity and nonnormality there may be issues of autocorrelation and non-stationarity
Model selection is not just a matter of maximizing Rbar-squared over
all possible models
Use economic theory and past studies to identify core variables and
if possible functional form
Test exclusion and other restrictions from a general model but
balanced against misspecification tests. Informed searches.

INEMET [U13783]

Guy Judge April 2007