Type author name/s here

Dougherty

Introduction to Econometrics,
5th edition
Chapter heading
Chapter 12: Autocorrelation

© Christopher Dougherty, 2016. All rights reserved.

 AUTOCORRELATION

Assumption C.5 states that the values of the disturbance term in the observations in the
sample are generated independently of each other.

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 AUTOCORRELATION

In the graph above, it is clear that this assumption is not valid. Positive values tend to be
followed by positive ones, and negative values by negative ones. Successive values tend
to have the same sign. This is described as positive autocorrelation.
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 AUTOCORRELATION

In this graph, positive values tend to be followed by negative ones, and negative values by
positive ones. This is an example of negative autocorrelation.

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 AUTOCORRELATION

Yt   1   2 X t  ut

First-order autoregressive autocorrelation: AR(1)

ut  ut 1   t

A particularly common type of autocorrelation, at least as an approximation, is first-order

autoregressive autocorrelation, usually denoted AR(1) autocorrelation.

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 AUTOCORRELATION

Yt   1   2 X t  ut

First-order autoregressive autocorrelation: AR(1)

ut  ut 1   t

It is autoregressive, because ut depends on lagged values of itself, and first-order, because

it depends only on its previous value. ut also depends on t, an injection of fresh
randomness at time t, often described as the innovation at time t.
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 AUTOCORRELATION

Yt   1   2 X t  ut

First-order autoregressive autocorrelation: AR(1)

ut  ut 1   t

Fifth-order autoregressive autocorrelation: AR(5)

ut  1ut 1   2 ut 2   3 ut 3   4 ut 4   5 ut 5   t

Here is a more complex example of autoregressive autocorrelation. It is described as fifth-

order, and so denoted AR(5), because it depends on lagged values of ut up to the fifth lag.

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 AUTOCORRELATION

Yt   1   2 X t  ut

First-order autoregressive autocorrelation: AR(1)

ut  ut 1   t

Fifth-order autoregressive autocorrelation: AR(5)

ut  1ut 1   2 ut 2   3 ut 3   4 ut 4   5 ut 5   t

Third-order moving average autocorrelation: MA(3)

ut  0 t  1 t 1  2 t 2  3 t 3

The other main type of autocorrelation is moving average autocorrelation, where the
disturbance term is a linear combination of the current innovation and a finite number of
previous ones.
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 AUTOCORRELATION

Yt   1   2 X t  ut

First-order autoregressive autocorrelation: AR(1)

ut  ut 1   t

Fifth-order autoregressive autocorrelation: AR(5)

ut  1ut 1   2 ut 2   3 ut 3   4 ut 4   5 ut 5   t

Third-order moving average autocorrelation: MA(3)

ut  0 t  1 t 1  2 t 2  3 t 3

This example is described as third-order moving average autocorrelation, denoted MA(3),

because it depends on the three previous innovations as well as the current one.

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 AUTOCORRELATION

ut  ut 1   t
3

0 1

-1

-2

-3

We will now look at examples of the patterns that are generated when the disturbance term
is subject to AR(1) autocorrelation. The object is to provide some bench-mark images to
help you assess plots of residuals in time series regressions.
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 AUTOCORRELATION

ut  ut 1   t
3

0 1

-1

-2

-3

We will use 50 independent values of , taken from a normal distribution with 0 mean, and
generate series for u using different values of .

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 AUTOCORRELATION

ut  0.0ut 1   t
3

0 1

-1

-2

-3

We have started with  equal to 0, so there is no autocorrelation. We will increase 

progressively in steps of 0.1.

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 AUTOCORRELATION

ut  0.1ut 1   t
3

0 1

-1

-2

-3

( = 0.1)

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 AUTOCORRELATION

ut  0.2ut 1   t
3

0 1

-1

-2

-3

( = 0.2)

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 AUTOCORRELATION

ut  0.3ut 1   t
3

0 1

-1

-2

-3

With  equal to 0.3, a pattern of positive autocorrelation is beginning to be apparent.

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 AUTOCORRELATION

ut  0.4ut 1   t
3

0 1

-1

-2

-3

( = 0.4)

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 AUTOCORRELATION

ut  0.5ut 1   t
3

0 1

-1

-2

-3

( = 0.5)

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 AUTOCORRELATION

ut  0.6ut 1   t
3

0 1

-1

-2

-3

With  equal to 0.6, it is obvious that u is subject to positive autocorrelation. Positive

values tend to be followed by positive ones and negative values by negative ones.

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 AUTOCORRELATION

ut  0.7ut 1   t
3

0 1

-1

-2

-3

( = 0.7)

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 AUTOCORRELATION

ut  0.8ut 1   t
3

0 1

-1

-2

-3

( = 0.8)

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 AUTOCORRELATION

ut  0.9ut 1   t
3

0 1

-1

-2

-3

With  equal to 0.9, the sequences of values with the same sign have become long and the
tendency to return to 0 has become weak.

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 AUTOCORRELATION

ut  0.95ut 1   t
3

0 1

-1

-2

-3

The process is now approaching what is known as a random walk, where  is equal to 1 and
the process becomes nonstationary. The terms ‘random walk’ and ‘nonstationary’ will be
defined in the next chapter. For the time being we will assume |  | < 1.
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 AUTOCORRELATION

ut  0.0ut 1   t
3

0 1

-1

-2

-3

Next we will look at negative autocorrelation, starting with the same set of 50 independently
distributed values of t.

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 AUTOCORRELATION

ut  0.3ut 1   t
3

0 1

-1

-2

-3

We will take larger steps this time.

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 AUTOCORRELATION

ut  0.6ut 1   t
3

0 1

-1

-2

-3

With  equal to –0.6, you can see that positive values tend to be followed by negative ones,
and vice versa, more frequently than you would expect as a matter of chance.

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 AUTOCORRELATION

ut  0.9ut 1   t
3

0 1

-1

-2

-3

Now the pattern of negative autocorrelation is very obvious.

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 AUTOCORRELATION

============================================================
Dependent Variable: LGHOUS
Method: Least Squares
Sample: 1959 2003
Included observations: 45
============================================================
Variable Coefficient Std. Error t-Statistic Prob.
============================================================
C 0.005625 0.167903 0.033501 0.9734
LGDPI 1.031918 0.006649 155.1976 0.0000
LGPRHOUS -0.483421 0.041780 -11.57056 0.0000
============================================================
R-squared 0.998583 Mean dependent var 6.359334
Adjusted R-squared 0.998515 S.D. dependent var 0.437527
S.E. of regression 0.016859 Akaike info criter-5.263574
Sum squared resid 0.011937 Schwarz criterion -5.143130
Log likelihood 121.4304 F-statistic 14797.05
Durbin-Watson stat 0.633113 Prob(F-statistic) 0.000000
============================================================

Next, we will look at a plot of the residuals of the logarithmic regression of expenditure on
housing services on income and relative price.

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 AUTOCORRELATION

0.04

0.03

0.02

0.01

0
1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003
-0.01

-0.02

-0.03

-0.04

This is the plot of the residuals of course, not the disturbance term. But if the disturbance
term is subject to autocorrelation, then the residuals will be subject to a similar pattern of
autocorrelation.
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 AUTOCORRELATION

0.04

0.03

0.02

0.01

0
1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003
-0.01

-0.02

-0.03

-0.04

You can see that there is strong evidence of positive autocorrelation. Comparing the graph
with the randomly generated patterns, one would say that  is about 0.7 or 0.8.

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Copyright Christopher Dougherty 2016.

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The content of this slideshow comes from Section 12.1 of C. Dougherty,

Introduction to Econometrics, fifth edition 2016, Oxford University Press.
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Individuals studying econometrics on their own who feel that they might benefit
from participation in a formal course should consider the London School of
Economics summer school course
EC212 Introduction to Econometrics
http://www2.lse.ac.uk/study/summerSchools/summerSchool/Home.aspx
or the University of London International Programmes distance learning course
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2016.05.22