March 29, 2013

Midterm Answers
1. Assume that growth rate of real GDP, xt follows xt = 0.008 + 0.38xt1 + t , where
t

N (0, 2 ) and = 0.01

(a) Find MA() representation of growth rate of GDP xt =

0.008 10.38

i=0

0.38i

ti

(b) Find mean of the process. Explain what it means to a 6-years-old (your boss). Ext =
0.008 10.38

= 0.013. Explanation: On average real GDP grows by 1.3%

every quarter or using rough approximation, on average real GDP grows by 5.1% every year. (c) Find variance of the process. Explain what it means to a 6-years-old (your boss). V ar(xt ) = E (xt Ext )2 = E (
i=0

0.38i

2 ti )

2 10.382

= 0.0001 thus

x = 0.01. Explanation: 99% of the time real GDP growth between 0.013 3 0.01 = 0.017 and 0.013 + 3 0.01 = 0.043 every quarter or, using rough approximation, 99% of the time real GDP growth is between -6.8% and +17.2% per year (this is type of uncertainty we have for actual gdp growth in U.S.). (d) What is the eect on growth rate of real GDP in period 5 of 1% unexpected decrease in period 0? Unexpected decrease in period 0 by 1% will decrease growth rate of real GDP in period 5 by
x5 0

= 0.385 or 0.8%.

2. Find autocovariance and autocorrelation function of the following process yt = t + t1

2 2 0 = Eyt = 1 + 2 2 1 = Eyt yt1 = ,

1 =

1 + 2

k = 0,

k = 0 , k 2

3. Fundamental representation (a) What is a fundamental representation? Fundamental representation is a unique way to write down a time series. (b) Complete the sentence: If two processes have the same fundamental representation .... they are the same time series process. (c) Is autocovariance function a fundamental representation? Yes. 4. Rewrite ARMA process xt = 1 xt1 + 3 xt3 + (a) in lag polynomial form, (1 1 L 3 L3 ) xt = (1 + 12 L12 ) (b) as homogeneous polynomial 3 + 1 2 + 3 = 0 (c) When this process will be stationary? When roots of homogeneous polynomial are inside unit circle |i | < 1 or when roots of AR lag polynomial 1 1 L 3 L3 are outside unit circle |i | > 1 (d) When this process will be invertible? Dene invertible. The process is invertible if we can re-write the ARMA process as innite AR, or invert MA lag polynomial. This is possible when roots of MA lag polynomial equation are outside unit circle.
t t

+ 12

t12

5. Stationary ARMA (a) Why before estimating a time series model we need to know if it is stationary? Because we have a single observation. If it is not stationary we cannot use averages like this
xt T

to estimate parameters, for example mean, variance,

or covariance. If time series is nonstationary the mean (or other moments) of such distribution changes every period. (b) Give a denition of weakly stationary series? Time series that have nite rst and second moments that do not change in time. More formally, Ext = Ext+k < , Ext xt+k = Ext+m xt+m+k < for any m and k . (c) Demonstrate that yt = t + t1 is stationary. yt has zero mean. Its autocovariance is nite and does not change in time as result in question 2 demonstrates. (d) When general ARMA is stationary? When roots of homogeneous polynomial are inside unit circle. (e) Is growth rate of real GDP in 1 stationary? What about level of real GDP? Growth: Yes, because 1 = 0.38 < 1. Level: No, because yt = implies that mean Eyt = time. (f) Roughly (without specic details) state Wold representation theorem. Any (nonlinear, complicated distribution, etc.) stationary process can be represented as innite sum of forecast errors or invertible M A(). 6. Monte-Carlo (a) You are given two vectors y and x of size 100 and OLS regression results y = x + with N (0, 2 ). Give a detailed description of steps of Montet i=1 t i=1

xt , which

Ext =

t i=1

0.013 = 0.013t is a function of

Carlo exercise(s) which allows you to demonstrate that following statements are true: 3

i. if H0 : = 0 is true, this t-statistic degrees of freedom.

OLS OLS ) se(

has t-distribution with 99

A. Step1: generate vector (100 by 1) errors y1 = t1 =

1 OLS OLS ) se(

N (0, 2 ); construct

(because according to H0 : = 0 ); regress y 1 on x; compute .

B. Step 2: repeat Step 1 10000 times to get {t1 , t2 , ..., t10000 }. C. Step 3: Use kernel density to compute empirical distribution based on {t1 , t2 , ..., t10000 } and plot it against theoretical t-distribution with 99 degrees of freedom. OLS = 2 is (-.2,3.1). Dene what condence ii. 95% condence interval for interval means given your result. A. Step1: generate vector (100 by 1) errors y 1 = 2x +
1 1

N (0, 2 ); construct

OLS = 2); regress y 1 on x; compute 1 . (because

1 , 2 , ..., 10000 }. B. Step 2: repeat Step 1 10000 times to get { s from smallest to largest; compare 250th to -.2 and C. Step 3: Order to 3.1. 9750th OLS were true and if we Denition: Condence interval shows that if draw residuals many times, constructed new ys and regressed new ys on would be between -0.2 and 3.1. x, in 95% of the time estimated iii. p-value for t-test in (i) for tOLS = 2 is 10%. Dene what p-value means given your result. A. Take {t1 , t2 , ..., t10000 } from i.B. s that are above 2 in absolute value; divide # by B. Step 3: Find # of t 10000; compare it to 10%. Denition: p-value shows that if true were zero and we would draw residuals many times, constructed new ys and regressed new ys on x, 10% of the time absolute value of our t-statistics would be above 2.

(b) Describe, in details, how to conduce a Monte-Carlo study to check than BoxPierce Q = T
s k=1 2 2 k distributed as s . Modify it to check Ljung-Box s k=1 2 2 k /(T k ) s . 1

modication Q = T (T + 2)

i. Step1: generate vector (100 by 1) errors

1

N (0, 2 ); construct y 1 =
s k=1

(because according to H0 : 1 = 2 = ...40 = 0 or the process 2 k (or Q =

s k=1

1 1 isWhite Noise); compute 1 s ; compute Q = T 1 ... T (T + 2) 2 k /(T k ) for Ljung-Box)

1, Q 2 , ..., Q 10000 }. ii. Step 2: repeat Step 1 10000 times to get {Q iii. Step 3: Use kernel density to compute empirical distribution based on 1, Q 2 , ..., Q 10000 } and plot it against theoretical 2 . {Q s