Functional Form selection

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Functional Form

Functional Form selection

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Models

Introduction

Discuss the importance of functional form

Examine the Ramsey Reset Test for

Functional Form

Describe the use of lags in econometric

models

Evaluate the Koyk transformation as a

means of overcoming some of the

problems of lagged variables

Functional Form

A further assumption we make about the

econometric model is that it has the correct

functional form.

This requires the most appropriate variables in

the model and that they are in the most suitable

format, i.e. logarithms etc.

One of the most important considerations with

financial data is that we need to model the

dynamics appropriately, with the most

appropriate lag structure.

Functional Form

It is important we include all the relevant variables in the

model, if we exclude an important explanatory variable,

the regression has omitted variable bias. This means

the estimates are unreliable and the t and F statistics

can not be relied on.

Equally there can be a problem if we include variables

that are not relevant, as this can reduce the efficiency of

the regression, however this is not as serious as the

omitted variable bias.

The Ramsey Reset test can be used to determine if the

functional form of a model is acceptable.

Form

This test is based on running the regression and

saving the residual as well as the fitted values.

Then run a secondary regression of the residual on

powers of these fitted values.

yt xt ut

2

ut 0 1 y t

3

2 y t

p

... p 1 y t

vt

The R-squared statistic is taken from the

secondary regression and the test statistic

formed: T*R-squared.

It follows a chi-squared distribution with (p-1)

degrees of freedom.

The null hypothesis is the functional form is

suitable.

If a T*R-squared statistic of 7.6 is obtained and

we had up to the power of 3 in the secondary

regression, then the critical value for chi-squared

(2) is 5.99, 7.6>5.99 so reject the null and the

functional form is a problem.

Lagged Variables

A possible source of any problem with the

functional form is the lack of a lagged

structure in the model.

One way of overcoming autocorrelation is

to add a lagged dependent variable to the

model.

However although lagged variables can

produce a better functional form, we need

theoretical reasons for including them.

Inertia of the dependent variable, whereby a

change in an explanatory variable does not

immediately effect the dependent variable.

The overreaction to news, particularly common

in asset markets and often referred to as

overshooting, where the asset overshoots its

long-run equilibrium position, before moving

back towards equilibrium

To allow the model to produce dynamic

forecasts.

Types of Lag

Autoregressive refers to lags in the

dependent variable

Distributed lag refers to lags of the

explanatory variables

Moving average refers to lags in the error

term (covered later).

ARDL Models

An Autoregressive Distributed lag model or

ARDL model refers to a model with lags of

both the dependent and explanatory variables.

An ARDL(1,1) model would have 1 lag on both

variables:

yt 0 1xt 2 xt 1 3 yt 1 ut

Differenced Variables

A differenced or change variable is used to

model the change in a variable from one

time period to the next. This type of variable

is often used with lagged variables to model

the short run.

yt yt yt 1

In econometrics the long and short run are

modelled differently. (later we will use

cointegration to model this).

The long-run equilibrium is defined as when

the variables have attained some steadystate values and are no longer changing.

In the long-run we can ignore the lags as:

yt yt 1 yt 2 y *

Long-Run

To obtain the long-run steady-state

solution from any given model we need to:

- Remove all time subscripts, including

lags

- Set the error term equal to its

expected value of 0.

- Remove the differenced terms

- Arrange the equation so that all x and

y terms are on the same side.

Long-run

For example given the following model, we

can use the previous rules to form a longrun steady-state solution:

yt 0 1xt 2 yt 1 3 xt 1 ut

0 0 2 y * 3 x *

2 y* 0 3 x *

0 3

y*

x*

2 2

Variables

The main problem is deciding how many lags to

include in a model.

The use of lagged dependent variables can

produce some econometric problems.

With a number of lags, there can be problems of

multicollinearity between the lags

There can be difficulties with interpreting the

coefficients on the lags and offering a theoretical

reason for their inclusion

Koyck Distribution

The Koyck distribution is a general dynamic

model with a number of applications.

The distribution has the lagged values of the

explanatory variables declining geometrically.

In the case of one explanatory variable it

follows the following form:

yt xt xt 1 2 xt 2 3 xt 3 ..... ut

1 1

Koyck Distribution

The previous model can not be estimated

using the usual OLS techniques as:

- There would almost certainly be

multicolliinearity

- There would be multiple estimates of the

and parameters, so it would be

impossible to identify its real value.

Koyck Transformation

It is possible to obtain a model which is

easier to estimate by performing the

Koyck transformation.

This requires the equation from earlier to

be lagged and multiplied by , so the

dependent variable is now y(t-1).

By subtracting this second equation from

the first, all the lagged values of x cancel

out.

Koyck Transformation

The Koyck transformation produces the

following model:

yt (1 ) xt yt 1 ut ut 1

The new constant is : (1 )

The new error term is : (ut ut 1 ) vt

Koyck Transformation

The transformed Koyck model produces

estimates of and , which can then be used to

produce estimates of the coefficients in the

original Koyck distribution.

This model allows both the short and long run to

be analysed separately, the previous model is

the short run, in the long run we ignore the lags

and error term to produce the following long-run

model.

Koyck Model

The long-run model is as follows:

y* (1 ) x * y *

y*

x*

1

Koyck Model

Although this transformed model appears better

than the original model it suffers from a problem.

The lagged dependent variable (y) is now an

explanatory variable and in the new error term

there is a lagged error term (u).

Given that both these terms appear in the original

Koyck distribution in non-lagged form they must be

related.

This means the fourth Gauss-Markov assumption

is failed, leading to biased and inconsistent OLS

estimates as:

Cov ( xt ut ) 0

Koyck Model

To obtain unbiased estimates of the

parameters in the transformed Koyck

model, we need to use an Instrumental

Variable (IV) technique. (This will be

covered later).

Alternatively we could use a non-linear

method to estimate the original Koyck

distribution, although this too requires an

alternative technique to OLS.

Koyck Transformation

Given the following estimates from a model of

income (y) on stock prices (s), we can use them to

interpret the original Koyck distribution on which

they are based:

(0.76) (0.04) (0.18)

R

0.65, DW 1.87

Koyck Transformation

The previous estimates can be used to

produce values for all the original

parameters, which can then be inputted into

the original Koyck distribution:

0.12

0.54

(1 ) 0.96

* (1 0.54) 0.96

0.96 / 0.46 2.09

Long-run

These estimates can also be used to

produce the long-run solution as follows:

s* /(1 ) y *

s* 2.09 0.12 /(1 0.54) y *

s* 2.09 0.26 y *

Conclusion

It is important to ensure the functional

form of the econometric model is correct.

This may require the inclusion of lags.

The use of lags and differenced variables

allows the examination of the short-run

dynamic properties of the model.

The Koyck distribution is a general model

for examining the dynamics.

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