Causality in Time Series:

The definition of causality: In dynamical systems theory, the necessary condition those two
variables (time-series) are causally linked each other, is that these two variables are
from the same dynamical system or they must share the same attractor.

Granger Causality:
Prof. Clive W.J. Granger, recipient of the 2003 Nobel Prize in Economics developed the
concept of causality to improve the performance of forecasting.
It is basically an econometric hypothetical test for verifying the usage of one variable in
forecasting another in multivariate time series data with a particular lag.
A prerequisite for performing the Granger Causality test is that the data need to be stationary
i.e it should have a constant mean, constant variance, and no seasonal component. Transform
the non-stationary data to stationary data by differencing it, either first-order or second-order
differencing. Do not proceed with the Granger causality test if the data is not stationary after
second-order differencing.
Let us consider three variables Xt , Yt , and Wt preset in time series data.
Case 1: Forecast  Xt+1 based on past values Xt . 
Case 2: Forecast Xt+1 based on past values Xt and Yt. 
Case3 : Forecast Xt+1 based on past values Xt , Yt , and Wt, where variable Yt has direct
dependency on variable Wt.
Here Case 1 is univariate time series also known as the autoregressive model in which there
is a single variable and forecasting is done based on the same variable lagged by say order p.
The equation for the Auto-regressive model of order p (RESTRICTED MODEL, RM)
Xt = α + 𝛾1 X𝑡−1 + 𝛾2X𝑡−2 + ⋯ + 𝛾𝑝X𝑡−𝑝      
where  p parameters (degrees of freedom) to be estimated.
In Case 2 the past values of Y contain information for forecasting Xt+1. Yt is said to “Granger
cause” Xt+1 provided Yt occurs before Xt+1 and it contains data for forecasting Xt+1.
Equation using a predictor Yt (UNRESTRICTED MODEL, UM)
Xt = α + 𝛾1 X𝑡−1 + 𝛾2X𝑡−2 + ⋯ + 𝛾𝑝X𝑡−𝑝 + α1Yt-1+ ⋯ + α𝑝 Yt-p 
2p parameters (degrees of freedom) to be estimated.
If Yt causes Xt, then Y must precede X which implies:
 Lagged values of Y should be significantly related to X.
 Lagged values of X should not be significantly related to Y.
Case 3 cannot be used to find Granger causality since variable Yt is influenced by variable
Wt .
 
Hypothesis test
Null Hypothesis (H0): Yt does not “Granger cause” Xt+1 i.e., 𝛼1 = 𝛼2 = ⋯ = 𝛼𝑝 = 0
Alternate Hypothesis (HA): Yt does “Granger cause” Xt+1, i.e., at least one of the lags of Y is
significant.
Calculate the f-statistic 
Fp,n-2𝑝−1 = (𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒 𝑜𝑓 𝐸𝑥𝑝𝑙𝑎𝑖𝑛𝑒𝑑 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒) / (𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒 𝑜𝑓 𝑈𝑛𝑒𝑥𝑝𝑙𝑎𝑖𝑛𝑒𝑑 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒)
 Fp,n-2𝑝−1 =  ( (𝑆𝑆𝐸𝑅𝑀−𝑆𝑆𝐸𝑈𝑀) /𝑝) /(𝑆𝑆𝐸𝑈𝑀 /𝑛−2𝑝−1) 
Where n is the number of observations and
SSE is Sum of Squared Errors.
If the p-values are less than a significance level (0.05) for at least one of the lags then reject
the null hypothesis.
Perform test for both the direction Xt->Yt and Yt->Xt.
Try different lags (p). The optimal lag can be determined using AIC.
 Limitation
 Granger causality does not provide any insight on the relationship between the variable hence
it is not true causality unlike ’cause and effect’ analysis.
 Granger causality fails to forecast when there is interdependency between two or more
variables (as stated in Case 3).
 Granger causality test can’t be performed on non-stationary data.

Exogeneity:

Exogeneity is a standard assumption made in regression analysis, and when used in reference
to a regression equation tells us that the independent variables X are not dependent on
the dependent variable (Y). This does not mean there is no connection; since Y is dependent,
it will still depend on the independent variable(s) X and on the error term.
When used to refer to a variable, it means that that particular variable is independent (not
affected by) other variables in the system. An exogenous variable is able to influence the
system without being influenced by it.

Types of Exogeneity
There are two main forms of exogeneity, depending on the level of independence shown by
the variable.

1. Strictly exogenous means the error term is unrelated to any instance of the variable X;
past, present, and future. X is completely unaffected by Y.
2. Sequentially exogenous means in which the error term is unrelated to past instances of
the variable X. A sequentially exogenous variable is also known as a predetermined
variable. X is not affected by past instances of Y; but future instances of X may be
affected by current or future instances of Y.
If an equation or variable is neither strictly exogenous nor sequentially exogenous, it is
called endogenous.

Example of Strict Exogeneity

Suppose you were modeling how the weather affected the probability of softball practice in a
small town in the Midwest. The weather is your independent variable, and it affects the
probability of softball practice, your dependent variable. The causal relationship is strictly
one way; the probability of softball practice is unable to affect the weather in any way. So
weather is an strictly exogenous variable.