4.

1 Autocorrelated errors

CLRM5: cov (  i ,  j ) = E ( i j ) = 0 for all i  j . This means that there is no

correlation between two error terms and hence the errors are said to be not
autocorrelated.

Here we are now considering what happens when this is no longer the case, i.e
when cov( i ,  j ) = E ( i j )  0 for all i  j .

We need to consider:

(i) what are the consequences for OLS estimation;

(ii) how do we detect whether the errors are autocorrelated or not;
(iii) how to deal with autocorrelated errors.

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Autocorrelated variables:

A time series variable is autocorrelated if it is correlated with itself at different

points in time. For a zero mean random variable X t , this is written as
E ( X t X s )  0 for t  s or
E ( X t X t − k )  0 for k = 1, 2,

For example, suppose that the variable follows a first-order autoregressive

process (AR(1)). This is where the variable is modelled as a function of itself
from the previous time period, i.e.

X t =  X t −1 +  t

where −1    1 and is a parameter called the autocorrelation coefficient.

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Let’s first look at the variance of this variable:

 X2 = var ( X t ) = var (  X t −1 +  t ) =  2 var ( X t −1 ) + var ( t ) =  2 var ( X t ) + var ( t )

=  2 X2 +  2  (1 −  2 )  X2 =  2 and therefore  X2 =  2
.
(1−  ) 2

Note: this proof has assumed that X t is homoskedastic, i.e. the variance is the
same no matter what time period we are in ( var ( X ) = var ( X ) ). t t −1

Now let’s look at the covariance between the variable and its first lag:

cov ( X t , X t −1 ) = E ( X t X t −1 ) = E ( (  X t −1 +  t ) X t −1 ) = E (  X t2−1 +  t X t −1 )

=  E ( X t2−1 ) =  var ( X t −1 ) =  var ( X t ) =  X2 =  2

.
(1−  ) 2

So, there is a non-zero first-order autocorrelation.

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We can also see that there is a non-zero second-order autocorrelation:

(
cov ( X t , X t −2 ) = E ( X t X t −2 ) = E ( (  X t −1 +  t ) X t −2 ) = E (  (  X t −2 +  t −1 ) +  t ) X t −2 )
= E ( X 2 2
+  t −1 X t −2 +  t X t −2 ) =  2 2
t −2
(1−  )
2

and in general

cov ( X t , X t − j ) = E ( X t X t − j ) =  j 2
(1−  ) .
2

Given that the autocorrelation coefficient is less than 1 in absolute value, then
 j → 0 as j →  . Hence as we look at autocorrelations further and further into the
past, the correlation gets smaller. This makes sense - a variable is more likely
to be correlated with itself in the near past than the distant past.

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The following are plots of a simulated AR(1) process X that exhibits no
autocorrelation (  = 0 ), positive autocorrelation (   0 ) and negative
autocorrelation (   0 ).

When  = 0 , the plot shows a fairly random pattern with no discernible pattern
or predictability.

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When  = 0.9 there is strong positive autocorrelation. Here, the pattern is
smoother with runs of positive and negative values and looks a bit like a cycle.

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When  = −0.9 there is strong negative autocorrelation. Negative
autocorrelation shows a spikier plot in which a positive value in one period is
likely to be followed by a negative value in the next period.

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This sub-section has shown you what autocorrelated variables in general look
like.

In Section 4, we are not considering autocorrelation in our regression variables,

although this might present problems for econometricians if we specified a
regression model that contained both the variable and its lags, as this might
cause a collinearity problem.

We are concerned here with autocorrelation that arises in the error terms of
our regression model, i.e if the disturbance  from a regression model is
autocorrelated.