Vector Auto Regression

Siddhartha Chattopadhyay
Department of Humanities and Social Sciences
IIT Kharagpur

Autumn 2018

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VAR Analysis

We have studied univariate time series modelling with

stationary time series data
AR, MA, ARMA, ARIMA
Captures important dynamics and facilitate forecast
VAR is multivariate extension of simple univariate model
several variables can be interrelated
they should be taken together to better understand the dynamics and
forecasting
mainly used in macroeconomics and …nance
Enders (2014) has several examples

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Structural VAR(1)

Suppose, fyt gTt=1 and fzt gTt=1 are two stationary time series
process that depends on each other
consumption and income
investment and interest rate
Structural VAR (1)

yt = b10 b12 zt + γ11 yt + γ12 zt

1 1 + εyt
zt = b20 b21 yt + γ21 yt 1 + γ22 zt 1 + εzt (1)

SVAR given in equation (1) cannot be estimated due to

Endogeneity originated from Simultaneity Bias
εyt a¤ects yt and yt a¤ects zt
εyt a¤ects zt ) εyt correlated with zt
inconsistent estimate

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Structural VAR(1)

b10 and b20 are drifts

b12 and b21 are contemporaneous parameters
εyt and εzt are white noise with mean zero and variance σ2y and σ2z
respectively

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Structural VAR(1)

Number of parameters to be estimated: 10

Drift: b10 and b20
Contemporaneous: b12 and b21
Lagged: γ11 , γ12 , γ21 , γ22
Variance: σ2y and σ2z

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Structural VAR(1)

SVAR given in equation (1) cannot be estimated due to

Endogeneity originated from Simultaneity Bias
εyt a¤ects yt and yt a¤ects zt
εyt a¤ects zt ) εyt correlated with zt
inconsistent estimate

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Structural VAR(1)

Equation (1) can be written in matrix notation as,

BXt = Γ0 + Γ1 Xt 1 + εt (2)

where,

1 b12 b
B = , Γ0 = 10
b21 1 b20
γ11 γ12 y ε
Γ1 = , Xt = t , εt = yt
γ21 γ22 zt εzt

and,
0 σ2y 0
V ( εt ) = E εt εt =
0 σ2z

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Reduced Form

Multiplying both sides of equation (2) by B 1 gives,

Xt = A0 + A1 Xt 1 + et (3)

where,

a10 a11 a12

A0 = B 1
Γ0 = , A1 = B 1
Γ1 =
a20 a21 a22
1 e1t 1 1 1 b12
et = B εt = , B =
e2t 1 b12 b21 b21 1

Equation (3) is VAR at Reduced Form

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Reduced Form VAR

Note,

0 0 σ21 σ12
E ( et ) = , V ( et ) = E et et =Σ=
0 σ21 σ22

σ2y + b12
2 σ2
z
σ21 = (1 b 12 b 21 )2
σ2z + b212 σ2
y
σ22 = (1 b 12 b 21 )2
b21 σ2y + b12 σ2z
σ12 = σ21 = (1 b 12 b 21 )2

et serially uncorrelated
) cov (e1t , e1t j ) = cov (e2t , e2t j) = 0, 8j 6= 0

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Estimation

Equation (3) is a System of Seemingly Unrelated Regression

Equation (SURE)
should be estimated by GLS. However, can be estimated by OLS too as
both equations in (3) has identical explanatory variables
In this case, OLS is identical with GLS (see, Greene, 2011)
Number of reduced form parameters can be estimated: 9
a10 , a20
a11 , a12 , a21 , a22
σ21 , σ22 , σ12

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Identi…cation

Impossible to identify 10 structural parameter separately from 9

reduced form parameters) VAR over parametrized
we have to impose restriction either by using theory or from a prior
information
here we have to impose (10 9) = 1 restrictions
Number of restrictions to be imposed to any n variables VAR
(p):

n (n 1)
2

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Identi…cation

There are di¤erent ways of imposing restrictions for

identi…cation
we can impose restrictions on the elements of B
we can impose restrictions on the elements of Σ
We will only learn Choleski Decomposition that imposes
restrictions on elements of B
it gives recursive structure to the system and makes the system exactly
identi…ed

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Identi…cation
Choleski Decomposition

Suppose we set b21 = 0

yt doesn’t have any contemporaneous impact on zt
It gives a recursive structure to the system where in ordering zt comes
before yt
Ordering is very important for Innovation Accounting (Impulse
Response Function and Variance Decomposition)

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Identi…cation of Contemporaneous Parameters
Choleski Decomposition

Estimate the reduced form and calculate estimated errors

Set one restrictions, e,g., b21 = 0
Estimate b12 by estimating the following system of equations

b
e2t = εzt
b
e1t = b12 εzt + εyt

distribution and t stats are calculated numerically by Bootstrapping

(see Enders supplementary Manual)

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Identi…cation of Contemporaneous Parameters
Choleski Decomposition

Estimate the reduced form and calculate estimated errors

b
Estimate V (et ) = Σ. Suppose the estimate is Σ.Note,
b 0
b (et ) = B ΣB
V

σ2y + b12
2 σ2
z
b21 =
σ (1 b 12 b 21 )2
σ2z + b212 σ2
y
b22 =
σ (1 b 12 b 21 )2
b21 σ2y + b12 σ2z
b12 = σ
σ b21 = (1 b 12 b 21 )2

We have 3 independent equations to solve for 4 parameters,

b12 , b21 , σ2y , σ2z ) put one restriction
distribution and t stats are calculated numerically by Bootstrapping
(see Enders supplementary Manual)
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Innovation Accounting
Impulse Response Function

Equation (3) can be written as,

1 1
Xt = (I A1 L ) A0 + ( I A1 L ) et
∞
= X + (I A1 L ) 1
B 1
εt = X + ∑ Aj1 B 1
εt j
j =0
∞
1 1 b12
= X + ∑ Aj1 εt j
j =0 1 b12 b21 b21 1
∞
= X + ∑ Φ (j ) εt j (4)
j =0

Equation (4) is a Vector Moving Average (VMA)

Representation of equation (1)

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Innovation Accounting
Impulse Response Function (IRF)

Equation (4) can be written as,

∞ ∞
yt = ∑ φ11 (j ) εyt j + ∑ φ12 (j ) εzt j
j =0 j =0
∞ ∞
zt = ∑ φ21 (j ) εyt j + ∑ φ22 (j ) εzt j (5)
j =0 j =0

Equation (5) gives IRFs

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Innovation Accounting
Impulse Response Function (IRF)

Diagonalization of A1 gives,

Aj1 = V Λj V 1

where, V is matrix of eigenvector of A1 and Λ is diagonal matrix of

eigenvalues
Stationarity of fyt gTt=1 and fzt gTt=1 implies both eigenvalues of
A1 are less than one in absolute value
converging IRFs: lim Xt + j ! X
j !∞

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Innovation Accounting
Impulse Response Function (IRF)

Ordering changes the IRFs by changing the structure of

contemporaneous matrix, B
Impact Multipliers: Φ (0)
captures the contemporaneous impact of shock on variables

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Innovation Accounting
Impulse Response Function (IRF)

Consider the following reduced form VAR

0.7 0.2
Xt = X + et
0.2 0.7 t 1

1 0.8
B =
0 1

Λ = diag (0.5, 0.9) )both variables are stationery and system stable

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Innovation Accounting
Impulse Response Function (IRF)

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Innovation Accounting
Impulse Response Function (IRF)

Panel (a): one unit rise in εzt

zt rises contemporaneously causing yt rise contemporaneously as shown
in solid line and hatched line respectively
IRFs gradually converging to zero
Panel (b): one unit rise in εyt
yt rises contemporaneously but not zt as yt does not have
contemporaneous impact on zt as shown in solid line and hatched line
respectively
IRFs gradually converging to zero

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Innovation Accounting
Variance Decomposition

Decomposes the percentage of forecast error variance of di¤erent

variables at di¤erent forecast horizon into
explained by the same variable
explained by others
a variable called exogenous if its forecast error variance is not explained
signi…cantly by the other variables.
exogenous variable is placed before the endogenous variable in ordering

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Innovation Accounting
Variance Decomposition

VAR allows forecasting:

from equation (4) a n period ahead forecast:
∞
Xt + n = X+ ∑ Φ (j ) ε t +n j,n = 1, 2, ....
j =0
(n 1 ) ∞
= X+ ∑ Φ (j ) ε t +n j + ∑ Φ (j ) ε t +n j
j =0 j =n
∞
Et ( X t + n ) = X+ ∑ Φ (j ) ε t +n j
j =n

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Innovation Accounting
Variance Decomposition

A n period ahead forecast error:

(n 1 )
Xt + n Et ( X t + n ) = ∑ Φ (j ) ε t +n j
j =0

Yields:
(n 1 ) (n 1 )
yt +n Et (yt +n ) = ∑ φ11 (j ) εyt +n j + ∑ φ12 (j ) εzt +n j
j =0 j =0
(n 1 ) (n 1 )
zt +n Et (zt +n ) = ∑ φ21 (j ) εyt +n j + ∑ φ22 (j ) εzt +n j(6)
j =0 j =0

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Innovation Accounting
Variance Decomposition

Forecast error variance:

0 (n 1 )
12
B
B ∑ φ11 (j ) εyt +n j C
C
j =0
E (yt +n Et (yt +n )) 2
= EB
B (n 1 )
C
C
@ A
+ ∑ φ12 (j ) εzt +n j
j =0
0 (n 1 )
12
B
B ∑ φ21 (j ) εyt +n j C
C
j =0
E (zt +n Et (zt +n )) 2
= EB
B (n 1 )
C
C (7)
@ A
+ ∑ φ22 (j ) εzt +n j
j =0

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Innovation Accounting
Variance Decomposition

Forecast error variance:

(n 1 ) (n 1 )
σ2y (n) = σ2y ∑ φ11 (j )2 + σ2z ∑ φ12 (j )2
j =0 j =0
(n 1 ) (n 1 )
σ2z (n) = σ2y ∑ φ21 (j )2 + σ2z ∑ φ22 (j )2 (8)
j =0 j =0

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Innovation Accounting
Variance Decomposition

Equation (8) can be written as,

σ2y (n 1 ) σ2z
(n 1 )

σ2y (n) j∑ 2 (n ) ∑
2
1 = φ 11 ( j ) + φ12 (j )2
=0 σ y j =0

σ2y (n 1 ) σ2z
(n 1 )

σ2z (n) j∑ 2 (n ) ∑
2
1 = φ 21 ( j ) + φ22 (j )2 (9)
=0 σ z j =0

Equation (9) decomposes the forecast error variance of both yt

and zt

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Exogeneity

z is exogenous when it is una¤ected by y both laggedly and

contemporaneously
(n 1 )
σ2y
needs, 2
σ z (n ) ∑ φ21 (j )2 = 0: y does not contribute to explain the
j =0
forecast error variance of z
happens when b21 = a21 = 0

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Granger Causality

y does not Granger Cause z when z is una¤ected by y only

laggedly. For VAR(1) model
H0 : y does not Granger Cause z
a21 = 0
Wald Test: W χ21
RRSS URSS
1
F test: URSS F1,T 6
T 6

6 is the number of explanatory variables including drift in the

unrestricted model of VAR(1)

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Granger Causality

For VAR(p) model:

H0 : y does not Granger Cause z for VAR (p )
a21 (1) = a21 (2) = ... = a21 (p ) = 0
Wald Test: W χ2p
RRSS URSS
p
F test: URSS Fp,T K
T k

K = n + pn 2 : number of explanatory variables including drift in the

unrestricted model of VAR (p)

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Selection of Lag Length

Estimate the model with maximum lag length

1
T 4
pmax = 12 100 and note down SBIC
Re-estimate the model with one reduced lag length but keeping the
number of usable observations unchanged and note down SBC
Continue in this fashion till you reach a model with one lag length
Choose the model with minimum SBIC

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Reference

Enders, W. (2014), Applied Econometric Time Series, 4th edition,

Wiley, USA
Enders, W. (2014), Applied Econometric Time Series Supplementary
Manual, 4th edition, Wiley, USA
Greene, W. H. (2018), Econometric Analysis, 8th edition, Pearson, US
Hamilton, J. D. (1994), Time Series Analysis, MIT Press, USA

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