Roll No C93/ECO/191022 Registration No 221-1221-0958-15

Paper No (with Code) CC8A Paper Name Econometrics II

Theory
Date of Examination 03/12/2020 Full Marks: 15

Q1. “Cointegration actually examines nature of stochastic trends between two or more time series”
– comment on it.

In most cases, when the variables y1,t and y2,t are non-stationary I(1) variables, a linear combination of
these variables will also be non-stationary. However, in a few cases the linear combination of these
variables may be stationary. This happens when the variables share the same stochastic trends, which
are cancelled out when combined. In these cases, we say that the variables are cointegrated.

To see how this translates into practice, consider two variables, y1,t and y2,t which are integrated of the
first order, I(1). When regressing these variables on one another, we could rearrange the linear
regression model, such that
ut=y1,t−β1y2,t

Now if the error term, ut is stationary, I(0), then by definition the combined y1,t−β1y2,t must also be
stationary, since the properties of the left-hand-side must equal the properties on the right-hand-side.
Hence, while both y1,t and y2,t have stochastic trends, we say that the variables y1,t and y2,t are
cointegrated, as the linear combination y1,t+β1y2,t has the same statistical properties as an I(0)
variable. Note that these stochastic trends are related through β1, which contains this feature (relating
to the common stochastic trends) of the data. Of course, if ut is non-stationary, I(1), as would usually
be the case, then y1,t and y2,t are not cointegrated and regressing y2,t on y1,t would yield a spurious
result.

Let us simulate two variables with the equations, y1,t=0.1+μy1t+υy1t and y2,t=0.3+μy2t+υy2t.
Both variables will have a positive drift so the two series increase over time as they are characterised
random-walks plus drift, where μy,t is the stochastic trend. Regressing y1,t on y2,t would usually produce
a spurious regression where the error is non-stationary (i.e. a shocks has a permanent effect on the
error term). However, in certain cases when we regress y1,t on y2,t we produce a stationary error In this
case the effects of stochastic trends have been removed.

To relate these results to a general specification, we make use of matrix algebra, where yt=(y1,t,y2,t)′ is
a (2×1) vector of I(1) variables. Then the coefficient matrix may be given as, β=(1−β1)′, where the
relationship between the variables could be summarised as β′yt=y1,t−β1y2,t. These variables will then be
cointegrated when β′yt∼I(0).
The linear combination of variables to derive β′yt will typically be motivated by economic theory and
this often referred to as the long-run equilibrium relationship. The idea is that variables in the yt vector
will drift together as they follow some form of long-run equilibrium. The vector β is termed the
cointegrating vector, which summarises the relationship between the stochastic trends. When
components of yt are integrated of order d and the reduction in the order of the combined variables
is b, then we note that yt∼CI(d,b) We will see that the concept of cointegration can easily be extended
to a setting with n variables. However, as we will discuss further, with n variables, there can only be a
maximum of n−1 linear combinations that are responsible for cointegrating relationships.
Q2. Explain why panel data provide more robust results as compared to cross section or time series
data in a linear regression model.

Answer: There are several reasons for which panel data provides more robust results as compared to
cross section or time series data in a linear regression model. Few have been mentioned below:

1. In panel data, the number of data points is increased. If there are N cross section units and T
time periods, then total number of observations will be NT. Therefore, in panel data degrees of
freedom is more providing more variability than in cross-sectional data or time series data. The
econometric estimates are more efficient if panel data are used.

2. Panel data are helpful in constructing and testing more complicated behavioural hypotheses.
One can control the unobserved heterogeneity among the individual cross section units by
using panel data.

3. Panel data contain information on intertemporal dynamics and may allow to control the effects
of unobserved variables in estimating a model. The collinearity between current and lag
variables can be reduced by using panel data. Long panel is useful to carry out dynamic
analysis.

4. P data are helpful in providing micro foundations for aggregate data analysis. If micro units are
heterogeneous, the time series properties of aggregate data will be very different from those
of disaggregate data. In this case, the prediction of aggregate outcomes by using aggregate
time series may be misleading. The use of panel data can resolve this problem by capturing the
heterogeneity issue.

5. In panel data, if observations among cross-sectional units are independent, one can show by
using the central limit theorem that the limiting distributions of many estimators remain
asymptotically normal even for nonstationary series.

Q.3 What would be the shape of ACF of a moving average process of order one? Discuss its
significance.

Answer: ACF is an (complete) auto-correlation function which gives us values of auto-correlation of any
series with its lagged values.

We consider a moving average process of order 1, Moving average pf order 1:

yt  t 1t1
Multiplying both sides of by yt-k and taking expectations,

E( yt ytk )  E(t ytk ) 1E(t1 ytk )

For k = 0,
   2   2 2  1   2  2

For k = 1,

 
E yt yt1  Et yt1  1 Et1 yt1 
or,1  1  2
Therefore,
1
 
1
1 12

For k  2,   k  0
Therefore, the MA(1) process has no correlation beyond lag 1.

Suppose that an MA(1) model is xt=10+wt+.7wt−1, where wt∼iidN(0,1). Thus the coefficient θ1=0.7.

The theoretical ACF is given by:

ρ1=0.7/(1+0.72)=0.4698, and ρh=0 for all lags h≥2

A plot of this ACF follows:

The plot just shown is the theoretical ACF for an MA(1) with θ1=0.7.

Significance:
If a time series shows a significant spike at lag 1 only then it is a possible MA (1) model.