Lecture 6 LBS Slides

Econometrics Part I
Lecture 6
6 November 2009
J. James Reade
Admin
Lectures:
Today: Simultaneous equations modelling and VARs.
Next week: Limited Dependent Variable Modelling.
Final lecture: Treatment eects and recap.
Lecture notes:
Handouts for each lecture: Slides.
Please point out typos!
Classes: This week, next week.
Exam: Two weeks on Tuesday.
Prep: Assignments best guide for exam.
Happy to chat via email or after lecture.
jjreade@gmail.com 2
Today: Multiple-Equation Modelling
Many reasons to estimate more than a single-equation model.
Panel: Time series observed over multiple units.
View as system of time series?
We may want to consider several models jointly:
Helpful if know disturbances likely correlated.
E.g. CAPM residuals (excess returns) over dierent rms correlated.
May want to consider determination of several variables jointly:
Endogeneity/simultaneity.
jjreade@gmail.com 3
Today: Textbook Coverage
Greene covers all material:
SURE: Chapter 14.
Simultaneous equations: Chapter 15.
VARs, etc: Chapter 19.
Another textbook gives good intro to simultaneous equations material:
Gujarati: Basic Econometrics, ed. 4, Chs 1821.
Gujarati somewhat more shaky on time-series grounds though.
Stock and Watson does not cover simultaneous equations.
jjreade@gmail.com 4
The Seemingly Unrelated Regression Model
Seemingly very similar to panel data.
Set of data for number of units, say rms.
May have cross equation dependencies, e.g. rms in similar industry.
May be more ecient to exploit error structure in estimation.
E.g. Consumer demand for N goods. Could estimate N demands.
But constraints hold over all consumer: Budget constraints etc.
These kind of models motivate the Seemingly Unrelated Regression approach.
Proposed by Zellner (1962).
jjreade@gmail.com 5
Take bivariate case: E.g. two goods, N observations for each:
y
1
= X
1
1
+u
1
u
1
(0,
2
1
), (1)
y
2
= X
2
2
+u
2
u
1
(0,
2
2
). (2)
Write as a system:
_
y
1
y
2
_
2N1
=
_
X
1
0
0 X
2
_
2N(K
1
+K
2
)
_

1
2
_
(K
1
+K
2
)1
+
_
u
1
u
2
_
2N1
. (3)
Stacked form:
y = X +u, E(u|X) = 0, Cov (u|X) = =
_

11
I
n

12
I
n
21
I
n

22
I
n
_
. (4)
Big regression problem: Use OLS?

OLS
= (X
X)
1
X
y. (5)
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OLS estimator has properties:
E
_
OLS
|X
_
= , Cov
_
OLS
|X
_
= (X
X)
1
X
X(X
X)
1
. (6)
Latter follows from assumption that Cov (u|X) = .
This is just a big OLS estimation: OLS on each equation seperately.
But is diagonal?
In many cases unlikely: CAPM example, demand expenditures.
If non-diagonal then OLS inecient.
Can gain over OLS by using GLS and exploiting cross-equation correlations.
Using GLS is called Seemingly Unrelated Regression (SURE) analysis.
jjreade@gmail.com 7
GLS estimator:
SURE
= (X
1
X)
1
X
1
y. (7)
Weve assumed non-diagonal:
=
_

11
I
n

12
I
n
21
I
n

22
I
n
_
. (8)
So
12
and
21
non-zero.
SURE estimation weights this information, in eect using parts of
1
in

2,SURE
.
Problematic if one equation in system misspecied as eects transmitted across
all equations.
jjreade@gmail.com 8
Alternative Systems of Equations
Panel data from last week seemingly a generalisation of SURE.
Although would appear SURE accounts for cross-section dependence.
1
May be interested not in the same data series over many dierent units of observation.
What if the variables for a given unit are endogenously determined?
In macroeconomics, its hard to see how data are anything but endogenous.
Demand and supply also.
Much of today: Simultaneous equation models.
Extending into VAR modelling.
1
Dont quote me on this.
jjreade@gmail.com 9
A Necessity for Simultaneous Equations
Endogeneity pervasive in econometric modelling.
Regression of y
i
on x
i
: y
i
= x
i
+
i
. (9)
But y
i
also depends on x
i
: x
i
= y
i
+e
i
. (10)
Estimator:

=
N
i=1
x
i
y
i
N
i=1
x
2
i
= +
N
i=1
x
i
N
i=1
x
2
i
. (11)
But E(x
i
i
) = E((y
i
+e
i
)
i
) = E(((x
i
+
i
) +e
i
)
i
) = E
_
2
i
_
= 0.
Endogeneity or simultaneity manifested in correlation between errors and variables.
Already considered many strategies for this ailment.
Today we consider estimating each possible equation.
jjreade@gmail.com 10
Multiple-Equation Modelling: Supply and Demand
E.g. Market for PhDs: Demand, supply, equilibrium wages (w) and employment (e).
Market clearing w, e caused by demand and supply.
But demand and supply aected by what w and e are.
Joint determination of equilibrium quantities.
Then quantity demanded of PhDs q
d
t
is: q
d
t
=
11
+
12
w
t
+
1t
. (12)
But the quantity supplied q
s
t
is: q
s
t
=
21
+
22
w
t
+
2t
. (13)
OLS estimation of either
12
or
22
problematic: Setting q
d
t
= q
s
t
gives:
w
t
=

11
21
22
12
+

1t
2t
22
12
, E(w
t
1t
) = 0, E(w
t
2t
) = 0. (14)
Multiple-Equation Modelling: Macroeconomics
Macroeconomic, or general-equilibrium, modelling:
Interested in joint determination of many variables.
E.g. Interest rates, output gap, ination.
Macro models specify equations for each of these variables.
All such systems have two types of variable:
Endogenous Variables: Determined with the model/system.
Exogenous Variables: Determined outside the model/system.
Also known as predetermined variables.
Multiple-Equation Modelling
Stylised model: M endogenous variables Y
1,t
, . . . , Y
M,t
, K exogenous variables
X
1,t
, . . . X
K,t
.
Implies M equations, one for each endogenous variable:
Y
1,t
=
12
Y
2,t
+
13
Y
3,t
+ +
1M
Y
M,t
+
11
X
1,t
+ +
1K
X
K,t
+
1,t
,
Y
2,t
=
21
Y
1,t
+
23
Y
3,t
+ +
2M
Y
M,t
+
21
X
1,t
+ +
2K
X
K,t
+
2,t
,
.
.
. =
.
.
. +
.
.
. + +
.
.
. +
.
.
. + +
.
.
. +
.
.
. ,
Y
M,t
=
M1
Y
1,t
+
M2
Y
2,t
+ +
M,M1
Y
M1,t
+
M1
X
1,t
+ +
MK
X
K,t
+
M,t
.
This is the structural form of an economic, or econometric model.
Endogenous variables in terms of other endogenous and exogenous variables.
Some or many coecients may be restricted to zero by theory a priori.
Structural and Reduced Form Modelling
Could write structural form instead as: BY
t
= GX
t
+
t
. (15)
Where:
B =
_
_
_
_
1
12

13
. . .
1M
21
1
23
. . .
2M
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
M,1

M,2

M,3
. . . 1
_
_
_
_
, G =
_
_
11
. . .
1K
.
.
.
.
.
.
.
.
.
M,1
. . .
M,K
_
_
,
t
=
_
_
_
_
1t
2t
.
.
.
Mt
_
_
_
_
, Y
t
=
_
_
_
_
Y
1t
Y
2t
.
.
.
Y
Mt
_
_
_
_
, X
t
=
_
_
_
_
X
1t
X
2t
.
.
.
X
Kt
_
_
_
_
.
Clearly modelling structural form has endogeneity problems.
Solve for endogenous variables in terms of exogenous variables. . .
The Reduced Form
Reduced form: Represent endogenous variables in terms of exogenous variables.
Y
t
= B
1
GX
t
+B
1
t
. (16)
E.g. PhDs job market: q
d
t
=
11
+
12
w
t
+
1t
, (17)
q
s
t
=
21
+
22
w
t
+
2t
. (18)
Reduced form here comes from equilibrium: q
s
t
= q
d
t
so:
w
t
=

11
21
22
12
+

1t
2t
22
12
=
0
+v
t
. (19)
Where:

0
=

11
21
22
12
, v
t
=

1t
2t
22
12
. (20)
Identication Diculties
Can now nd equilibrium quantity from either original equation:
q
t
=
11
+
12
_
11
21
22
12
+

1t
2t
22
12
_
+
1t
, (21)
=

11
22
12
21
22
12
+

22
1t
12
2t
22
12
=
1
+e
t
. (22)
Where:

1
=

11
22
12
21
22
12
, e
t
=

22
1t
12
2t
22
12
. (23)
These are reduced-form equations for wage w
t
and quantity employed q
t
.
Can estimate
0
,
1
: No endogeneity problem remains.
But
0
,
1
are non-linear functions of
11
,
12
,
21
,
22
, the structural parameters.
Cannot uncover structural parameters from reduced form estimation: Unidentied.
Identication
Identication achieved if unique values of structural parameters can be found.
Main interest in PhD model are structural parameters
11
,
12
,
21
,
22
:
q
d
t
=
11
+
12
w
t
+
1t
, (24)
q
s
t
=
21
+
22
w
t
+
2t
. (25)
But OLS estimation biased and inconsistent due to E(w
t
it
) = 0, i = 1, 2.
Reduced form estimators
0
,
1
are consistently estimated by OLS.
But cannot recover
11
,
12
,
21
,
22
from
0
,
1
.
Our parameters of interest are unidentied, or underidentied.
Identication Conceptually
Recall from microeconomic theory: Market price satises demand and supply.
(q
t
, w
t
) are set of equilibrium prices:
Intersections of dierent demand and supply curves.
q
w
y
y
y
y
y
y
y
Identication Conceptually
Recall from microeconomic theory: Market price satises demand and supply.
(q
t
, w
t
) are set of equilibrium prices:
Intersections of dierent demand and supply curves.
q
w
y
S
1
D
1
y
S
1
D
1
y
S
1
D
1
y
S
1
D
1
y
S
1
D
1
y
S
1
D
1
y
S
1
D
1
Identication Diculties
Identication: Many observationally equivalent representations.
Could add to demand equation, 1 to supply:
q
d
t
=
11
+
12
w
t
+
1t
, (26)
(1 )q
s
t
= (1 )
21
+ (1 )
22
w
t
+ (1 )
2t
. (27)
Adding the two equations together yields:
q
d
t
=
1
+
2
w
t
+
1t
, (28)
Where:
1
=
11
+(1)
21
,
2
=
12
+(1)
22
,
t
= (1)
1t
+(1)
2t
.
New equation (28) indistinguishable from demand or supply equations.
Cannot tell which is which from data alone.
Seeking Identication
Method for identication: Additional information.
E.g. Include extra shift variable in demand equation.
Then can conceptually move that variable to shift demand curve.
Trace out supply curve.
q
w
y
S
1
D
3
y
D
2
y
D
1
y
D
4
y
D
5
For PhDs, add extra variable to demand equation to nd supply equation.
Add student enrolments s
t
to demand equation. Need lecturers to lecture.
q
d
t
=
11
+
12
w
t
+
11
s
t
+
1t
, (29)
q
s
t
=
21
+
22
w
t
+
2t
. (30)
Then reduced form is: w
t
=
0
+
1
s
t
+v
t
, q
t
=
2
+
3
s
t
+u
t
. (31)
Where:

0
=

21
11
12
22
,
1
=

11
22
12
, v
t
=

2t
1t
12
22
,
2
=

12
21
11
22
12
22
,
3
=

11
22
22
12
, u
t
=

12
2t
22
1t
12
22
.
Five unknowns, four equations. But:

21
=
2
22
0
,
22
=

3
1
. (32)
Hence supply equation identied.
Checking Identication
As earlier, we can add and (1 ) to each equation:
q
t
=
0
+
1
w
t
+
2
s
t
+
t
. (33)

k
and
t
dened accordingly.
Hence: This new representation indistinguishable from demand equation:
Demand unidentied: Can take any linear combination of equations.
But supply identied: Can distinguish supply from (33) by s
t
term.
We identify supply equation by adding term to demand equation:
Extra demand term allows us to trace out supply curve.
Regression means can hold all else xed, vary s
t
.
Shifts demand curve while supply xed:
What we get must be supply curve.
Can repeat trick to identify demand: Add term to supply equation.
Add consultancy wage rate c
t
to supply equation. Outside option.
Add student enrolments s
t
to demand equation. Need lecturers to lecture.
q
d
t
=
11
+
12
w
t
+
11
s
t
+
1t
, (34)
q
s
t
=
21
+
22
w
t
+
21
c
t
+
2t
. (35)
Will yield reduced forms: w
t
=
0
+
1
s
t
+
2
c
t
+v
t
, (36)
q
t
=
3
+
4
s
t
+
5
c
t
+u
t
. (37)
6 unknowns: (
11
,
12
,
21
,
22
,
11
,
21
), 6 equations: (
0
,
1
,
2
,
3
,
4
,
5
).
All parameters identied, both equations identied.
Overidentication
Other factors inuence demand and supply. E.g. for PhDs, previous period wage.
q
d
t
=
11
+
12
w
t
+
11
s
t
+
1t
, (38)
q
s
t
=
21
+
22
w
t
+
21
c
t
+
22
w
t1
+
2t
. (39)
Usual problem of simultaneity bias means we look for reduced form:
w
t
=
0
+
1
s
t
+
2
c
t
+
3
w
t1
+v
t
, (40)
q
t
=
4
+
5
s
t
+
6
c
t
+
7
w
t1
+u
t
. (41)
Got eight equations (s) for only seven structural parameters. E.g.:
22
=
6
/
2
,
22
=
5
/
1
. (42)
Overidentication
Got eight equations (
i
s) for only seven structural parameters. E.g.:
22
=
6
/
2
,
22
=
5
/
1
. (43)
Model overidentied: Too much information.
We exclude two variables for just one endogenous variable in supply function.
Multiple expressions for parameters such as
22
may give dierent answers.
Ambiguity transmitted to other parameters:
22
in denominators of other
i
s.
But TMI not necessarily a bad thing:
Estimation methods exist to handle extra information.
Identication More Formally
Identication very dicult to grasp and to nd.
Rank and order conditions exist to check for identication:
Facilitate nding identication via automation in computer packages.
Recap and extension of notation:
M: Number of endogenous variables in model/system.
m: Number of endogenous variables in equation of model.
K: Number of exogenous, predetermined variables in model/system.
k: Number of exogenous, predetermined variables in equation of model/system.
The Order Condition
Order condition is necessary but not sucient for identication.
Can be stated in two ways:
1. In model of M simultaneous equations, equation identied if:
It excludes at least M 1 variables (endogenous or otherwise).
If less than M 1 excluded, unidentied.
If exactly M 1 excluded, just identied.
If more than M 1 excluded, overidentied.
2. In M-equation system, equation identied if:
Number of exogenous variables excluded bigger than number of endogenous
variables in equation minus 1:
K k m1. (44)
The Order Condition: Examples
Simple demand example: q
d
t
=
11
+
12
w
t
+
1t
, (45)
q
s
t
=
21
+
22
w
t
+
2t
. (46)
Two endogenous variables, M = 2, each equation excludes zero variables.
Unidentied.
Add student enrolment: q
d
t
=
11
+
12
w
t
+
11
s
t
+
1t
, (47)
q
s
t
=
21
+
22
w
t
+
2t
. (48)
Two endogenous variables, M = 2, K = 1.
Demand equation: Excludes zero variables hence unidentied.
Supply equation: Excludes one variable variable hence identied.
The Order Condition: Examples
Add student enrolment, consultancy wages and lagged wages:
q
d
t
=
11
+
12
w
t
+
11
s
t
+
1t
, (49)
q
s
t
=
21
+
22
w
t
+
21
c
t
+
22
w
t1
+
2t
. (50)
Two endogenous variables, M = 2, three exogenous K = 3.
Demand equation: Excludes two variables (c
t
, w
t1
) hence overidentied.
Supply equation: Excludes one variable (s
t
) variable hence identied.
But we already know supply equation actually overidentied.
The Order Condition
Order condition probably most commonly used identication strategy.
Use theory to argue why particular variables excluded.
E.g. Rainfall aects supply and not demand for wheat.
Rainfall is stark example: Not always so in economics.
E.g. Ricardian equivalence: Debt has no real eect?!
Implications of wrong identication strategy not innocuous:
But very hard to test!
The Rank Condition
Order condition necessary but not sucient for identication.
Even if satised equation may not be identied.
E.g. If s
t
insignicant in demand equation,
11
= 0, supply unidentied.
Identication also violated if exogenous variables excluded not independent:
If linear combination exists, mapping from s and s to s non-unique.
Rank Condition:
M-equation system identied i at least one non-zero determinant of order (M
1)(M 1) can be constructed using coecients (endogenous or exogenous) of
variables excluded from that equation.
Necessary and sucient condition for identication.
Rank Condition: An Example
System of 4 endogenous Y variables and 3 exogenous X variables:
Y
1t
10
12
Y
2t
13
Y
3t
11
X
1t
= u
1t
, (51)
Y
2t
20
23
Y
3t
21
X
1t
22
X
2t
= u
2t
, (52)
Y
3t
30
31
Y
1t
31
X
1t
32
X
2t
= u
3t
, (53)
Y
4t
40
41
Y
1t
42
Y
2t
43
X
3t
= u
4t
. (54)
Identied?
Eq. No K k m1 Identied?
(51) 2 2 Exactly
(52) 1 1 Exactly
(53) 1 1 Exactly
(54) 2 2 Exactly
Rank Condition: An Example
To help with rank condition write equations in table:
Coecients of the variables
Eq No. 1 Y
1
Y
2
Y
3
Y
4
X
1
X
2
X
3
(51)
10
1
12

13
0
11
0 0
(52)
20
0 1
23
0
21

22
0
(53)
30

31
0 1 0
31

32
0
(54)
40

41

42
0 1 0 0
43
To check equation (51): Form matrix of coecients on Y
4
, X
2
, X
3
:
A =
_
_
0
22
0
0
32
0
1 0
43
_
_
, det A = 0. (55)
Hence A not full rank: Rows/columns not linearly independent.
Relationships exist between variables hence unidentied.
Cannot tell (52) and (53) apart hence cant tell (51) from either.
More on Identication
Order condition necessary but not sucient, rank condition necessary and sucient.
Rank tells us whether identied or not, order whether exact- or over-identication.
Four cases:
1. If K k > m1 and rank (A) = M 1 equation overidentied.
2. If K k = m1 and rank (A) = M 1 equation exactly identied.
3. If K k m1 and rank (A) < M 1 equation under identied.
4. If K k < m1 equation unidentied.
Rank condition can get dicult with large dimension systems:
Often just order condition used if software cannot calculate.
Testing for Simultaneity
If we have no simultaneity problem then OLS consistent.
If we do have simultaneity then need 2SLS/IV to come.
Thus testing for simultaneity helpful. Hausman (1976) provided a test.
Consider model: Q
d
t
=
0
+
1
P
t
+
2
X
t
+
1t
, (56)
Q
s
t
=
0
+
1
P
t
+
2t
. (57)
Reduced form: P
t
=
0
+
1
X
t
+v
t
, (58)
Q
t
=
2
+
3
X
t
+e
t
. (59)
OLS gives:

P
t
and P
t
=

P
t
+ v
t
.
Sub back into supply: Q
t
=
0
+
1
P
t
+
1
v
t
+
2t
.
Testing for Simultaneity
Test equation: Q
t
=
0
+
1
P
t
+
1
v
t
+
2t
=
0
+
1
P
t
+ v
t
+
2t
.
If simultaneity then v
t
correlated with
2t
:
v
t
is variation remaining in P
t
controlling for exogenous variables.
We have split P
t
into potentially simultaneous component via instrumenting.
If simultaneity then v
t
signicant if run OLS on test equation. Since:
T
t=1
Q v
t
T
t=1
v
2
t
=
T
t=1
Q(P
t

P
t
)
T
t=1
v
2
t
. (60)
Hence Hausman test for simuntaneity is t-test on olsv
t
:
If test rejected, conclude simultaneity.
Estimation
Estimating system: BY
t
= GX
t
+
t
(61)
M endogenous variables in M 1 matrix Y
t
, M M coecient matrix B.
K exogenous variables in K 1 matrix X
t
, M K coecient matrix G.
Recall reduced form:
Y
t
= B
1
GX
t
+B
1
t
= X
t
+u
t
. (62)
OLS estimation of consistent.
But rarely of interest: These are reduced-form parameters.
B, G more of interest but not necessarily identied.
Estimation
Two estimation methods:
1. Limited Information Methods:
Estimate each equation of system separately.
Take into account restrictions on that equation, not others.
2. Full Information Methods:
Estimate all equations jointly, or simultaneously.
Impose all restrictions on all equations (required for identication).
Other Special Cases
If the model is recursive, also known as triangular or causal, then:
B =
_
_
_
_
_
_
_
1 0 0 . . . 0
21
1 0 . . . 0
31

32
1 . . . 0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
M1

M2

M3
. . . 1
_
_
_
_
_
_
_
. (63)
I.e. Y
1
causes Y
2
causes Y
3
etc. hence no endogeneity problems.
Also require that Cov (
t
) = is diagonal, i.e. C
it
,
jt
= 0 for all j = i.
Here OLS is consistent.
Other Special Cases
Vector autoregression: E.g. VAR(2):
X
t
=
1
X
t1
+
2
X
t2
+
t
. (64)
Here:
X
t
=
_
_
_
_
X
1t
X
2t
.
.
.
X
pt
_
_
_
_
. (65)
Model has no contemporaneous values of X
1
, . . . , X
p
on RHS hence OLS consistent.
Usually economic theory imposes structure on contemporaneous variables:
BX
t
=
1
X
t1
+
2
X
t2
+
t
(66)
Then again got issue of endogeneity.
More on VARs later. . .
Limited Information Methods
In just-identied case, we can use indirect least squares (ILS). Model:
q
d
t
=
0
+
1
p
t
+
2
s
t
+
1t
, (67)
q
s
t
=
0
+
1
p
t
+
2
c
t
+
2t
. (68)
Proceed in three steps:
1. Find reduced-form equations:
Endogenous variables in terms of only exogenous variables.
p
t
=
0
+
1
s
t
+
2
c
t
+u
t
,
q
t
=
3
+
4
s
t
+
5
c
t
+u
t
.
2. Estimate reduced-form equations by OLS:
Yields consistent estimates of reduced-form parameters as no endogeneity.
Produces

1
, . . . ,
5
.
3. Obtain estimates of structural coecients by one-to-one correspondence:
Requires just-identication to get
1
, . . . ,
2
.
Limited Information Methods
ILS breaks down if equation overidentied:
More than one possibility for each parameter, standard errors dubious.
Say model is: q
d
t
=
0
+
1
p
t
+
2
s
t
+
3
p
t1
+
1t
,
q
s
t
=
0
+
1
p
t
+
2
c
t
+
2t
.
Problem remains that p
t
endogenous hence E(p
t
1t
) = 0.
Require method to isolate component of p
t
correlated with
1t
.
Can use instrumental variable estimation:
Exogenous variables s
t
, p
t1
, c
t
satisfy one instrumenting condition.
Namely uncorrelatedness with the error term.
Expect relevance condition to hold otherwise unidentied.
Method: Two-stage least squares
Two-Stage Least Squares
1. Regress endogenous variable p
t
on all exogenous variables in system:
p
t
=
0
+
1
s
t
+
2
p
t1
+
3
c
t
+u
t
. (69)
Yields estimates
0
, . . . ,
3
to use to get tted values p
t
.
p
t
is variation in p
t
explained by exogenous variables.
Hence uncorrelated with error component.
u
t
= p
t
p
t
is remaining component correlated with error.
2. Run original system equation using p
t
in place of p
t
:
q
d
t
=
0
+
1
p
t
+
2
s
t
+
3
p
t1
+
1t
. (70)
Resulting estimate
1
consistent provided exogenous variables valid instruments.
Isolate and remove component of p
t
correlated with error term by instrumenting.
Can estimate even if model overidentied as here.
More on 2SLS
2SLS estimator:
2SLS
= (Z
i
X
i
)
1
(Z
i
y
i
) = + (Z
i
X
i
)
1
(Z
i
). (71)
Where Z
i
is vector of exogenous variables, X
i
endogenous and y
i
dependent.
As before, need E(Z
i
X
i
) = 0 and E(Z
i
) = 0 for consistency:
I.e. Need exogenous variables be exogenous and to identify system.
First stage provides test of relevance of instruments.
Need to ensure standard errors correctly calculated on second stage:
Use p
t
not p
t
to calculate residuals hence standard errors etc.
Full Information Methods
Write as stacked system: y = Z +, (0, ). (72)
Or:
_
_
_
_
y
1
y
2
.
.
.
y
M
_
_
_
_
=
_
_
_
_
Z
1
0 . . . 0
0 Z
2
. . . 0
.
.
.
.
.
.
.
.
.
.
.
.
0 0 . . . Z
M
_
_
_
_
_
_
_
_
2
.
.
.
M
_
_
_
_
+
_
_
_
_
2
.
.
.
M
_
_
_
_
. (73)
Here: Z
m
= (Y
m
, X
m
), hence both endogenous and exogenous variables.
OLS estimator:
OLS
= (Z
Z)
1
Z
y. (74)
OLS on system equivalent to equation-by-equation OLS hence inconsistent.
Also by SUR inecient: Does not exploit information in .
Full Information: 3SLS
Method to solve inconsistency:
Instrumental Variables estimation.
Method to solve ineciency:
Feasible GLS estimation.
Hence nd estimator in three stages:
Three-stage least squares:
1. Instrumenting equation estimation:
Use all exogenous variables X as instruments.
Yielding

to create

Y
i
=

X
i
, where i = 2, . . . , M for equation 1, etc.
Gives matrix

Z
i
formed of

Y
1
and X
i
.
2. Instrumental variables estimation:
Use

Z
i
in place of Z
i
.
Yields 2SLS estimators

2SLS
:
2SLS
= (
Z)
1
(
y) = (W
Z)
1
W
y. (75)
Estimator consistent only if E(W
) = 0, E(W
Z) = 0.
Also get variance-covariance matrix estimator

:

2
ij
= T
1
(y
i
Z
i
i
)
(y
j
Z
j
j
). (76)
3. Feasible GLS estimation:
Use

Z and

from 2SLS estimates.
IV,GLS
=

3SLS
= (
1
Z)
1
1
y = (W
1
Z)
1
W
1
y. (77)
3SLS consistent provided instruments are valid.
Asymptotic eciency amongst system IV estimators.
Full-Information Maximum Likelihood (FIML)
Likelihood framework can be applied to system.
Begin with reduced-form: Y = X +V. (78)
Each row of V assumed multivariate Normal: v
i
|X N(0, ).
Log-likelihood function: ln L =
T
2
_
M ln(2) + ln || + tr
_
1
W
_
. (79)
Where: W
ij
= T
1
(y X
i
)
(y X
j
). (80)
Here,
i
is i
th
column of not the number.
Maximise likelihood subject to all restrictions placed on system: B matrix.
Reduced form Y = X +V found from structural form:
Y = XB +U, U (0, ),
Y = XB
1
+U
1
, U
1
(0,
1
1
).
Interested in structural form not reduced form so use substitutions:
= B
1
, =
1
1
,
1
=
1
. (81)
Hence:
ln L =
T
2
_
M ln(2) + ln
+ tr
_
(Y +XB
1
)
(Y +XB
1
)
_
.
Again:
ln L =
T
2
_
M ln(2) + ln
+ tr
_
(Y +XB
1
)
(Y +XB
1
)
_
.
Simplied: ln L =
T
2
_
M ln(2) 2 ln || + ln || + tr
_
1
S
_
.
Where: s
ij
= T
1
(Y
i
+XB
i
)
(Y
j
+XB
j
). (82)
Maximise likelihood to yield , B matrices:
Full-Information Methods
FIML:
Coherent estimation framework.
Testing feasible via LR, LM, Wald tests.
But: Normality assumption may not be valid.
But: Numerical optimisation.
3SLS:
Vastly easier to compute: No numerical methods.
If Normal errors assumed, 3SLS and FIML same asymptotic properties.
3SLS thus much more popular in usage.
Small samples: Because many parameters to estimate, 3SLS and FIML may diverge.
Simultaneous Equation Methods Condensed
Often need to estimate more than one equation:
Similar regression for dierent rms, goods, etc.
Equations for all endogenous variables in system.
Estimation:
Instrumental variables to counter endogeneity.
Exogenous variables are instruments.
Full- or limited-information (IV) methods:
Full can be computationally cumbersome.
Limited information methods inecient.
Break time?
Adding Lagged Variables: Vector Autoregressions
Simultaneous equations models often used in time-series context:
Huge macroeconomic models of 1960s and 1970s:
Klein-Goldberger model of US economy: 20 equations.
Brookings-Social Science Research Council model: 150 equations.
Models need not be time series but generally are.
What if many lags included? Stability?
Alternative simultaneous equations model:
The Vector Autoregression (VAR not VaR).
Only endogenous variables, but no contemporaneous terms.
Often used for theory-free estimation or forecasting.
Vector Autoregressive Models
Already noted second-order VAR: Two lags:
X
t
=
0
+
1
X
t1
+
2
X
t2
+
t
.
_
_
X
1,t
.
.
.
X
p,t
_
_
=
_
_
0
1
.
.
.
0
p
_
_
+
_
_
1
11
. . .
1
1p
.
.
.
.
.
.
.
.
.
1
p1
. . .
1
pp
_
_
_
_
X
1,t1
.
.
.
X
p,t1
_
_
+
_
_
2
11
. . .
2
1p
.
.
.
.
.
.
.
.
.
2
p1
. . .
2
pp
_
_
_
_
X
1,t2
.
.
.
X
p,t2
_
_
+
_
_
1,t
.
.
.
p,t
_
_
.
All variables X
1
, X
2
, . . . , X
p
determined within system. Endogenous.
But: No variables dated t enter each equation:
Hence can apply time-series methods to estimate.
The Vector Autoregressive Model
Object of interest: set of variables over time:
X
t
p-dimensional data vector at time t:
X
t
=
_
_
_
_
X
1,t
X
2,t
.
.
.
X
p,t
_
_
_
_
. (83)
p variables relating to particular problem of interest:
X
t
is snapshot at point in time:
X
t
=
_
_
_
_
_
_
_
(tax/Y )
t
(G/Y )
t
(D/Y )
t
t
Y
gap
t
_
_
_
_
_
_
_
=
_
_
_
_
_
_
_
2008:3
0.180
0.218
0.695
0.053
0.022
_
_
_
_
_
_
_
. (84)
X is p T data vector:
X =
_
_
_
_
_
_
_
(tax/Y )
(G/Y )
(D/Y )
Y
gap
_
_
_
_
_
_
_
=
_
_
_
_
_
_
_
1966:1
0.172
1966:2
0.176
1966:3
0.176
1966:4
0.176 . . .
2008:3
0.180
0.165 0.172 0.174 0.177 . . . 0.218
0.416 0.405 0.409 0.408 . . . 0.695
0.023 0.028 0.033 0.037 . . . 0.053
0.058 0.050 0.046 0.042 . . . 0.022
_
_
_
_
_
_
_
. (85)
The Vector Autoregressive Model
p X
p,t
variables:
Same variable, dierent countries/regions/rms/people: e.g. exchange rates.
Dierent variables, same country/region/rm/person: e.g. consumption, income.
Can view as reduced-form modelling:
Without assuming exogeneity.
Can test exogeneity assumptions easily.
Variable X
p,t
exogenous if determined outside system.
Hence if all coecients on X
s,tk
insignicant, p = s, k > 0, X
p,t
exogenous.
Can then omit equation in X
p,t
from system.
Similar to Granger causality test: More later. . .
What are VARs Used For?
Forecasting:
All RHS variables are lagged: Can forecast tomorrow given todays data.
Theory-free modelling:
Sims: No need for incredible restrictions implied by theory.
Theory-full modelling:
VARs correspond well to reduced form of many macroeconomic theory models.
Theory interested in eect of impulse to variables through time:
E.g. Eect of government spending on GDP.
What are VARs Used For?
VARs give extremely rich characterisation of dynamics in data.
Autoregressive and distributed lag components.
Can cope with unit roots as in AR(k) model: Cointegration.
Deterministic terms can be incorporated (with care).
No conditioning or exogeneity assumed.
Many theories in economics and wider postulate steady states.
Yet data are non-stationary and endogenous.
Concept of cointegration means can estimate steady state.
VAR model allows endogeneity and testing of exogeneity.
Cointegration
If Y
t
, X
t
both I(d) then in general any linear combination will also be I(d).
If there exists linear combination e
t
= Y
t
X
t
s.t. e
t
I(d b), b > 0 then:
Y
t
, X
t
are cointegrated of order (d, b).
In reality rarely nd anything other than cointegration of order (1, 1): Cointegration.
Cointegration very powerful concept in time-series econometrics.
Recall spurious regression? Brazilian rainfall causes UK GDP?
Cointegration allows estimation of levels relationships in data.
Even if data non-stationary.
Same spuriousness possible in VAR, simultaneous equation modelling.
Going back to our ADL Model
ADL model: Y
t
= +
1
Y
t1
+
0
X
t
+
1
X
t1
+
t
. (86)
Error/equilibrium-correction mechanism (ECM) with long-run solution nested is:
Y
t
=
0
X
t
+ (
1
1)
_
Y
t1

1
1
0
+
1
1
1
X
t1
_
+
t
. (87)
Dene ecm
t
as long-run solution: ecm
t
= Y
t

1
1
0
+
1
1
1
X
t
. (88)
Subtract [/ (1
1
) (
0
+
1
) X
t
/ (1
1
)] from both sides of ADL:
ecm
t
=

1
1
+
1
Y
t1
+
_
0
+
1
1
1
_
X
t
+
1
X
t1
+
t
. (89)
Collect terms and adding and subtracting a term in X
t1
to create ecm
t1
:
ecm
t
=
1
_
Y
t1

1
1
0
+
1
1
1
X
t1
_
+
_
1
(
0
+
1
)
1
1
+
1
_
(X
t1
X
t
) +
t
=
1
ecm
t1
+
_
1
+
1
0
1
1
_
(X
t1
X
t
) +
t
=
1
ecm
t1
+
t
.
Where:
t
=
t
1
+
1
0
1
1
_
t
.

t
is error term on random walk for X
t
:
t
= X
t
X
t1
.
Hence: ecm
t
=
1
ecm
t1
+
t
, I(0). (90)
What was that for?
We just found that: ecm
t
=
1
ecm
t1
+
t
, I(0). (91)
Thus provided |
1
| < 1, then ecm
t
I(0):
Recall:
ecm
t
= Y
t

1
1
0
+
1
1
1
X
t
.
ecm
t
is long-run solution for Y
t
and X
t
, steady state.
Steady-state relationships can exist in context of non-stationary model.
Cointegration: X
t
I(1), Y
t
I(1), but ecm
t
= f (Y
t
, X
t
) I(0).
Fundamental concept in econometrics:
Even though data non-stationary can still estimate static steady-state conditions.
Appeals to common sense and to economic theory: Allows estimation.
Y
t
=
0
X
t
+ (
1
1) [Y
t1
1
X
t1
] +
t
. (92)
All Good, but What About Estimation?
Cointegrating relationship is static: Y
t
= X
t
+ecm
t
, ecm
t
N
_
0,
2
ecm
_
.
Thus no problems with estimating: no residual autocorrelation.
Despite dynamic nature of relationship, can estimate static equation.
Furthermore: its super consistent: estimate converges to true value very fast.
2
Suggests a procedure: Estimate ecm
t
, insert that into ECM and estimate.
Engle-Granger 2-step procedure.
Intuitive and encompasses test for cointegration: is ecm
t
I(0)?
2
It converges at rate T as opposed to
T for normal estimator.

That Cointegration Test
Form of ADL and ECM suggest cointegration test of ADF form:
ecm
t
= ecm
t1
+
p1
i=1
i
ecm
ti
+ +t +
t
,
t
N
_
0,
2
_
. (93)
Include trend and constant either to (93) or to ecm
t
equation.
Since (93) just residuals from ecm
t
equation.
Cointegration test: H
0
: = 0. (94)
However, cannot use Dickey-Fuller distribution.
Must use MacKinnon (1991) critical values: See Table 4.1, Harris and Sollis.
Sounds Too Good to be True?
Unfortunately, it is.
Banerjee et al (1993):

biased in small samples.

has very complicated distribution: cannot draw standard inference.
The test of cointegration has low power:
Rejects null (no cointegration) too infrequently when null false.
Thus we conclude in favour of cointegration too little.
Endogeneity issues: often in macro systems feedback Y
t
to X
t
.
More than one steady-state relationship?
Fiscal and monetary policy: why not two cointegrating relationships?
Cannot estimate more than one here.
Solutions?
Numerous other estimation strategies suggested for single-equation framework.
But: all suer from endogeneity problem and cant estimate > 1 relationships.
Solution: Simultaneous equations, or vector autoregressive model (VAR).
Johansen (1996) proposed VAR approach.
Workhorse of cointegration analysis.
A rst order autoregressive model
We can build up to the VAR(k) in several steps. . .
First order autoregressive (AR(1)) process: x
t
= x
t1
+ +
t
. (95)
Model solution: Recursive substitution:
x
t
=
t
x
0
+
t
i=1
i
( +
i
) . (96)
Moving average representation.
Cases:
1. Stationarity: z
1
, . . . , z
t
(strongly) stationary if:
(z
1
, . . . , z
t
)
D
= (z
s
, . . . , z
t+s
) s.
Weak, or covariance, stationary if:
E(z
t
) = , Cov (z
t
, z
ts
) = (s), t.
With
t
N(0, ), weak strong.
Stationary Case
If || < 1, characterise model as:
E(x
t
|x
0
) =
t
x
0
+
t
i=1
i

1
Var (x
t
|x
0
) = E
_
2i
i=1
2i
2
i
_
=
t
i=1
2i

2
1
2
Cov (x
t
, x
tk
|x
0
) = E
_
tk
i=1
2i
2
i
_
=
tk
i=1
2i

2
1
2
.
Process stationary asymptotically but not in small samples.
Case 2: Unit-root
If = 1: x
t
= x
0
+
t
i=1
( +
i
) , (97)
So:
E(x
t
|x
0
) = x
0
+t
Var (x
t
|x
0
) =
2i
i=1
2
i
=
t
i=1
2
= t
2
.
Mean, variance functions of t: non-stationary.
Unit root case corresponds many economic data series.
3. Explosive case: > 1 not considered: innity and beyond. . .
Moving-average Representations
MA representation: easy to characterise the data process under consideration.
Principle same for more complicated models.
Also recall lag operator L s.t. L
k
x
t
= x
tk
. If || < 1:
x
t
x
t1
=
t
(98)
x
t
(1 L) =
t
(99)
x
t
= (1 L)
1
t
=
t
+
t1
+
2
t2
+. . . ,
(100)
Alternative derivation that assumed stationarity.
Impulse response analysis
MA representation also facilitates impulse response analysis.
If economy shocked (impulsed) now, where will it be in h periods?
Formally written:
x
t+h
=
h
x
t
+
t+h
i=t
i
( +
i
). (101)
Taking expectations: E(x
t+h
|x
t
) =
h
x
t
+
t+h
i=t
i
. (102)
Impulse response dened as: IR(h) =
E(x
t+h
|x
t
)
x
t
=
h
. (103)
If stationary, || < 1 then IR(h) =0: impulse dies away.
If unit root, = 1, then IR(h) = 1 h: shock cumulates, never dies away.
If explosive, || > 1, IR(h) .
Three Impulse Responses
0 10 20 30 40 50 60 70 80 90 100
0.5
1.0
Stationary process
x
t
=0.6x
t1
+
t

0 10 20 30 40 50 60 70 80 90 100
0.5
1.0
Random walk process
x
t
=1x
t1
+
t

0 10 20 30 40 50 60 70 80 90 100
5
10
15
Explosive process
x
t
=1.03x
t1
+
t

Some Caution on Impulse Responses. . .
IR analysis phenomenally popular in empirical studies.
Impulse to residual of statistical model = economic shock.
Even if model is identied.
Retail Energy Prices and Consumer Expenditures by Paul Edelstein and Lutz Kilian:
IR but no formal checks on model: Condence in output?
Can impose restrictions to identify structure so it accords to theory:
But in VARs, IRs heavily dependent on particular restrictions.
Identication restrictions generally not test-able.
Causality very dicult to achieve in macroeconomics.
(Identication is on comtemporaneous terms in VAR)
Impulse response analysis intuitively great but fraught with diculties.
The AR(2) Model
Model: x
t
=
1
x
t1
+
2
x
t2
+
t
. (104)
Lag operator:
_
1
1
L
2
L
2
_
x
t
=
t
(L)x
t
=
t
(105)
Characteristic (lag) polynomial dened as:
(z) = 1
1
z
2
z
2
= (1
1
z) (1
2
z) , (106)
1
(z)
=
1
(1
1
z) (1
2
z)
=
i
1
z
i
i
2
z
i
=
n
c
n
z
n
, (107)
c
n
0 as n if |
1
| < 1, |
2
| < 1, so MA() exists: x
t
=
n=0
c
n
( +
tn
) .
Taking expectations: E(x
t
|x
0
) =
n=0
c
n
=

(1
1
)(1
2
)
=

1
1
2
.
Impulse Response Analysis Again
Want to know impact at t +h of impulse at t:
x
t+h
=
n=0
c
n
( +
t+hn
) (108)
= c
0
(
t+h
) +c
1
(
t+h1
) +. . .
+c
h1
(
t+1
) +c
h
(
t
) +c
h+1
(
t1
) +. . .
(109)
= +c
h
(x
t
1
x
t1
2
x
t2
) +. . . (110)
Only residual
t
matters: rest set to zero.
Hence:
IR(h) =

x
t
E(x
t+h
|x
0
, . . . , x
t
) = c
h
0. (111)
Same implications as before for unit root, explosive cases.
Bi-variate VAR(2) model with deterministic terms
Model: X
t
=
1
X
t1
+
2
X
t2
+
t
(112)
_
X
1,t
X
2,t
_
=
_

1,11

1,12
1,21

1,22
__
X
1,t1
X
2,t1
_
+
_

2,11

2,12
2,21

2,22
__
X
1,t2
X
2,t2
_
+
_

1,t
2,t
_
.
(113)
Characteristic polynomial dened as:
(z) = I
2
1
z
2
z
2
=
_
1
1,11
z
2,11
z
2
1,12
z
2,12
z
2
1,21
z
2,21
z
2
1
1,22
z
2,22
z
2
_
.
(114)
z scalar,
k,ij
is ij
th
element of
k
.
As in univariate system, use (z) to characterise properties of model.
Multivariate equivalent to solving for roots is to solve det((z)) = 0:
det((z)) = (1
1
z)(1
2
z)(1
3
z)(1
4
z) = 0, (115)

i
functions of
1
,
2
.
Linear algebra:
(z)
1
=
adj((z))
det((z))
, (116)
adj((z)) adjoint/adjugate matrix: each element at most order 2 as matrix 2 2.
So convergence of (z)
1
depends on det((z)).
We already have det((z)) so:
(z)
1
=
adj((z))
det((z))
=
P(z)
(1
1
z)(1
2
z)(1
3
z)(1
4
z)
= P(z)
_
_
i=0
i
1
z
i
j=0
j
2
z
j
k=0
k
3
z
k
m=0
m
4
z
m
_
_
=
n=0
P
n
z
n
,
P(z) second order function of z incorporated into P
n
P
n
exponentially convergent if |
i
| < 1.
If |
i
| < 1 MA() representation:
X
t
=
i=0
P
i
(D
ti
+
ti
) = (L)
1
(D
t
+
t
) ,

1
(z) =
i=0
P
i
z
i
.
Hence E(X
t
) =
i=0
P
i
D
ti
, V ar(X
t
) =
i=0
P
i
P
i
.
X
t
not stationary as D
t
depends on t, but X
t
E(X
t
) is stationary.
The companion form of a vector autoregressive model
Carrying on with VAR(2), useful expression is companion form:
_
X
t
X
t1
_
=
_

1

2
I
2
0
__
X
t1
X
t2
_
+
_
D
t
+
t
0
_
(117)
=

X
t
+v
t
, (118)
,

X
t
, v
t
suitably dened.
is companion matrix:
VAR(p) reduced to VAR(1) representation
Useful for characterising model via MA representation.
Roots of companion matrix = roots of system, found by solving eigenvalue problem:
det
__

1

2
I
2
0
_
_
I
2
0
0 I
2
__
= 0. (119)
Equivalently:
_

1

2
I
2
0
__
v
1
v
2
_
=
_
I
2
0
0 I
2
__
v
1
v
2
_
, (120)
Implying:

1
v
1
+
2
v
2
= v
1
,
v
1
= v
2
,
1
v
1
+
2
1
v
1
= v
1
. (121)
det(AI) = 0 Av = Iv then (121) det(
1
1
) = 0, or:
1
v
1
+
2
2
v
1
= v
1
det(I
2
2
) = 0. (122)
If roots of characteristic polynomial () outside the unit circle, then roots of
companion matrix (
1
) inside unit circle, system stationary.
Intuition as in AR(1): stationarity conditions enable MA() representation, allow
characterisation of model.
The unrestricted vector autoregressive model
The unrestricted VAR model with two lags is:
X
t
=
1
X
t1
+
2
X
t2
+ D
t
+
t
Dene:
B =
_
_
_
_
W
t
=
_
_
X
t1
X
t2
D
t
_
_
, (123)
Can simplify:
X
t
= B
W
t
+
t
. (124)
The Assumptions of the VAR Model
The VAR(p) depends on a number of assumptions:
1. (X
t
|X
t1
, X
t2
, . . . , X
tp
) mutually independent.
2. (X
t
|X
t1
, X
t2
, . . . , X
tp
) N(
1
X
t1
+ +
p
X
tp
+ D
t
, ).
Conditional Normality.
3. Parameter space exists.
Vital that assumptions hold.
Likelihood framework gives powerful tool for economic analysis.
But price is distributional assumption.
Maximum likelihood estimation of the unrestricted VAR
First dene likelihood function:
Joint density of X
t
given parameter set .
Autoregressive structure requires sequential factorisation: no independence
assumption.
f(X
t
, X
t1
, . . . , X
1
, X
0
) =
T
t=k
f(X
t
|X
t1
, . . . , X
tk
). (125)
Likelihood dened as:
L(; X
t
) =
T
t=k
f(X
t
|X
t1
, . . . , X
tk
; ). (126)
Maximum likelihood estimator of given data X
t
dened as:
= max
L(; X
t
), (127)
Value of that, given assumed distribution, maximises likelihood function.
Measure of plausibility: how plausible is particular parameter value?
Logarithms often used to make likelihood function tractable:
= max
log L(; X
t
) = max
((|) ; X
t
). (128)
For VAR, Normality assumption implies:
(; X
t
) = T
p
2
ln(2) T
1
2
ln ||
1
2
T
t=1
(X
t
B
W
t
)
1
(X
t
B
W
t
) .
Likelihood maximisation implies, for

B
:
min
B
T
t=0
(X
t
B
W
t
)
2
(129)
0 =
T
t=0
(X
t
B
W
t
) W
t
(130)
=
T
t=0
X
t
W
t
_
T
t=0
W
t
W
t
_
1
= M
XW
M
1
WW
. (131)
ML Estimators:

B
= (
1
,
2
,
).
Product moment matrices are generically dened as M
XW
=
T
t=0
X
t
W
t
.
Furthermore:
t
= X
t
W
t1
(132)
= T
1
T
t=0

t

t
= M
XX
M
XW
M
1
WW
M
WX
, (133)
Maximised Likelihood
Use estimators in likelood:
L
max
= L(

B,

) = (2)
Tp/2
T/2
exp
_
1
2
tr
_
1
T
t=1

t

t
__
(134)
L
2/T
max
= (2e)
p
. (135)
Very powerful result for testing:
Regardless of model estimated with Normal distribution, get this result.
Can impose restrictions, estimate, get

R
and

B
R
and get:
L
2/T
R
= (2e)
p
. (136)
Likelihood ratio test has easy form: ratio of residual variances.
Testing with the Maximum Likelihood Framework
Likelihood framework allows easy testing: likelihood ratio test.
Test the hypothesis: H
0
: =
0
, (137)
Using test statistic:
LR = 2
_
log L(
0
; X
t
) log L(
; X
t
)
_

2
dim
. (138)
Test assesses plausibility of restrictions.
If restrictions move likelihood too far from

, reject restrictions.
Restrictions on

B
formed by constructing matrices R or H Lecture 3.

Using H form, restrictions imposed by = HB:
X
t
= HB
Z
t
+
t
= Z
t
+
t
. (139)
Estimating gives restricted estimators, denoted by checks:
= M
XZ
H (H
M
ZZ
H)
1
(140)
= M
XX
M
XZ
H (H
M
ZZ
H)
1
M
ZX
(141)
Likelihood ratio test: 2 ln(LR) = T ln
_
2
r
. (142)
Test statistic simple and intuitive.
The VAR Likelihood Framework
VAR is simultaneous equations autoregressive model.
Allows rich characterisation of dynamics of data.
Equivalent to reduced form of economic theory models.
Likelihood estimation consistent as no endogeneity.
Also ecient as estimated.
Provided VAR well specied, powerful tool for exploring data:
Forecasting.
Impulse response analysis.
Investigating steady-state relationships: Cointegration.
Issues of causality and exogeneity.
Checking the VAR
VAR provides much information on modelled data.
Johansen (2004): which statistical model describes the data?
Statistical models rely on assumptions, properties proved based these.
Must test assumptions hold.
Check on unrestricted VAR before proceeding cointegration analysis.
Choice of number of cointegrating vectors vital.
Akin to deciding whether data I(1) or I(0).
Choice aected by model misspecication.
The Assumptions of the VAR model
VAR model assumes:
1. Linear conditional mean explained by past observations and deterministic terms:
Testing: Un-modelled systematic variation in residuals:
Informal: plots of residuals.
Formal: test for autocorrelated errors, heteroskedasticity and ARCH.
Remedy by:
Choice of lag length.
Choice of information set composition of X
t
.
Incorporate outliers.
Data transformations: Non-linearity.
Structural breaks: Non-constant parameters, deterministic terms.
Assumptions (continued. . . )
2. Time-invariant conditional variance:
Heteroskedasticity and ARCH eects:
Informal: plots of residuals.
Formal: White test, ARCH test.
Remedy:
Add potentially causal regressors?
Regime shifts in the variance: deterministic terms.
3. Independent Normal errors, mean zero, variance :
Informal testing: histogram of residuals
Formal testing: Autocorrelation test on residuals.
4. Parameter space:
All model outcomes plausible?
Remedy: data transformation e.g. logs for % change.
Cointegration in the VAR
Data generally non-stationary: assume X
t
I(1).
As with AR(1), reformulate: Error correction form of VAR:
X
t
= X
t1
+
1
X
t1
+ +
k1
X
tk+1
+ D
t
+
t
. (143)
=
_
k
i=1
i
_
1,
j
=
k
i=j+1
i
.
X
t
I(0),
t
I(0), but X
t
I(1) still. (143) unbalanced.
Solution: reduced rank. Then p r matrices , s.t. =
:
X
t
=
X
t1
+
1
X
t1
+ +
k1
X
tk+1
+ D
t
+
t
. (144)

X
t1
I(0): I(0) combinations of I(1) variables: cointegrating vectors.
A Bivariate Example
Example: r = 1, p = 2, 2 1 so
X
t1
=
_

1
2
_
_

1

2
_
_
X
1,t1
X
2,t1
_
=
_

1
2
_
(
1
X
1,t1
+
2
X
2,t1
) .

X
t
: Stationary Linear combination of I(1) variables.

1
,
2
: speed of adjustment of variables in X
t
to disequilibrium.

i
= 0 implies X
i,t
weakly exogenous.
X
1,t
, X
2,t
: consumption and income, home and foreign interest rate. . .
Very powerful framework for analysis of steady-state relationships.
Can check if more than one variable adjusts to steady-state.
No empirical examples today: If interested I can provide more slides.
Granger Causality
Causality central to economics and other elds:
Does money cause GDP, or GDP cause money?
Does advertising cause sales? Or sales cause advertising?
The VAR framework allows us to answer these questions.
A variable X
t
is Granger non-causal for Y
t
if:
E(Y
t
|Y
t1
, X
t1
, . . . ) = E(Y
t
|Y
t1
) . (145)
I.e. Previous values of X
t
do not provide information on Y
t
.
Same as strong exogeneity.
If (145) does not hold, implication is X
t
Granger causal for Y
t
.
But need also that Y
t
Granger non-causal for X
t
.
Rule out feedback, establish causality.
Granger Causality
Can easily test Granger causality in VAR model. E.g. bivariate VAR(2):
X
t
=
1
X
t1
+
2
X
t2
+
t
(146)
_
X
1,t
X
2,t
_
=
_

1,11

1,12
1,21

1,22
__
X
1,t1
X
2,t1
_
+
_

2,11

2,12
2,21

2,22
__
X
1,t2
X
2,t2
_
+
_

1,t
2,t
_
.
(147)
If
1,21
=
2,21
= 0 then lags of X
1,t
2,t
.
If
1,12
= 0,
2,12
= 0 then X
2,t
Granger causal for X
1,t
.
Hence X
2,t
1,t
.
Powerful test of causality often used in literature.
Granger Causality
But general case: tri-variate VAR(2):
_
_
X
1,t
X
2,t
X
3,t
_
_
=
_
_
1,11

1,12

1,13
1,21

1,22

1,23
1,31

1,32

1,33
_
_
_
_
X
1,t1
X
2,t1
X
3,t1
_
_
+
_
_
2,11

2,12

2,13
2,21

2,22

2,23
2,31

2,32

2,33
_
_
_
_
X
1,t2
X
2,t2
X
3,t2
_
_
+
_
_
1,t
2,t
3,t
_
_
.
(148)
If
1,21
=
2,21
= 0 then lags of X
1,t
2,t
.
If
1,12
= 0,
2,12
= 0 then X
2,t
1,t
.
But what about causality from X
1,t2
to X
3,t1
to X
2,t
?
Need also
2,31
=
1,23
= 0.
Granger Causality
Granger causality extensively used in empirical work.
Powerful and intuitive test of causality.
Reliant on VAR framework.
Could be run as series of single equation estimations.
Thought inecient.
But it is severely limited:
With many lags, complicated structure of zero restrictions required.
Test is conditional on information set included:
Hence unmodelled lags or variables may provide causality.
Hence Granger non-causality conclusion may be invalidated.
Advertising: Copenhagen Cointegration Summer School
Learn from the Masters!
Three week course in August each year:
August 323 2009: register your interest!
http://www.econ.ku.dk/summerschool/
Mornings: Cointegration theory from Juselius, Johansen, Rahbek and Nielsen.
Afternoons: Computer labs to work on your own dataset.
Hugely useful course:
Submit paper at end of course for feedback.
Potential PhD chapter.
Concluding
In-depth look at multiple-equation modelling.
Seemingly Unrelated Regression:
E.g. Demand systems.
Exploit information between regressions.
Simultaneous-equation modelling:
E.g. Demand and supply systems.
Endogeneity problem.
IV estimation: Instruments are exogenous variables.
VAR modelling:
Extending the time series dimension.
Forecasting, theory-free/full modelling, impulse responses, Granger causality.
Next week: Limited-Dependent-Variable Modelling.

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Econometrics Part I

T for normal estimator.

formed by constructing matrices R or H Lecture 3.

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