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TOPIC 7:

VECTOR
AUTOREGRESSIVE
MODELS AND ITS
APPLICATION
By:
Assoc. Prof. Dr. Sallahuddin Hassan
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Applied Econometrics

INTRODUCTION
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Some variables are not only


explanatory variables for a given
dependent variable, but they are
also explained by the variable that
they are used to determined.
Model of simultaneous equations
exogenous, endogenous and
predetermined.
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INTRODUCTION

According to Sim (1980), if there is


simultaneity among a number of
variables, then all these variables should
be treated in the same way.
Therefore, there should be no distinction
between endogenous and exogenous
variables. All variables should be
treated as endogenous variable.

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INTRODUCTION
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This situation leads to the


development of the VAR model.
Why we need VAR:

The VAR model is a general framework


to describe the dynamic interrelationship
between stationary variables.
We are not really confident that a
variable is actually exogenous.
Performing forecasting analysis.
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FEATURES OF A VAR
MODEL

Equations are identified.


Can be estimated by OLS and get consistent
estimators.
All variables are endogenous. Only lagged
endogenous variables on RHS.
All variables are assumed stationary.
Coefficient in reduced form not structural
parameter.
Contemporaneous effect captured by residuals.
are uncorrelated white-noise error terms.
1t & 2t
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VAR MODEL
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VAR is a multiple equation system.

A set of k time series regressions.


The regressors are lagged values of
all k series.

Let begin with two time-series


variables:
yt
xt
and
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VAR MODEL
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The dynamic relationship of two


variables yield a system of equations:
yt 10 11 yt 1 12 xt 1

y
t
x
t

xt 20 21 yt 1 22 xt 1

Each variable is a function of its own


lag and the lag of the other variable
in the system.

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VAR MODEL
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If yt and xt are stationary


variables,
VAR model is:
y
yt 10 11 yt 1 12 xt 1 t

xt 20 21 yt 1 22 xt 1

x
t

The above system can be


estimated using OLS.
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I 0

VAR MODEL
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If yt and xt are nonstationary


I 1
variables, and not cointegrated,
we work with the first difference.
VAR model is:
yt 11yt 1 12 xt 1 ty
xt 11yt 1 12 xt 1 tx

All variables are now


. The
I 1
system can be estimated
using OLS
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VECM MODEL
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If yt andxt are nonstationary


1
Ivariables,
and cointegrated
We need to modify the system of
equations to allow for the
cointegrating relationship
between the nonstationary
variables.
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VECM MODEL
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Why we do this?

To retain and use valuable information


about the cointegrating relationship.
To ensure the best technique that take
into account the properties of time series
data.

VEC Model needs to be used. It is a


special form of the VAR for nonstationary
variables that are cointegrated.
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VECM MODEL
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Model:
Yt 1 11 Yt 1 0 1 X t 1 v1t

X t 2 21 Yt 1 0 1 X t 1 v 2t

The VECM model allows us to examine


how much
will change in response to
yt
a change in the explanatory variable (the
cointegration part, ), as well as the speed
of the change (the error correction part,
ECTt 1
)
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VECM MODEL
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General VECM specification:

Yt 1 ECTt 1 X t t
is the impact multiplier (the short-run
effect) that measures the immediate
impact that
X t a current change in Yt will have
on a change in .

is the feedback effect or the adjustment


effect, and shows the speed of adjustment
1
or how much of the disequilibrium is being
corrected.
To ensure stability.
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SPECIFICATION ISSUES
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Logs or no logs?
How many variables?

The number of coefficients in each


equation is proportional to the number
of variables.
Keep the number of variables small:

to ensure plausible relationship among


variables.
to avoid estimation error
forecasting
accuracy.
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SPECIFICATION ISSUES
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Differences (yt) or levels (yt)?

If all I(0), then level.


If some I(1) but cointegrated,
then level of ECM.
If I(1) but not cointegrated, then
difference to I(0).

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SPECIFICATION ISSUES
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How many lags?

Enough to eliminate autocorrelation but


as few as possible.
Too many lags consume degree of
freedom and multicollinearity
( and
x1
x2
are linearly dependent)
Too few lags specification error (omitting
influential or including non-influential
explanatory variables and omission of
relevant or inclusion of irrelevant
irrelevant variables)
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SPECIFICATION OF VAR
MODEL
1) Testing for stationarity

Find out a given time series is


stationary or non stationary.
Performing unit root tests DF, ADF,
or PP tests.
Double click on the series and
choose View/Unit Root
Test/Perform test
specification/OK
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Unit Root Test


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SPECIFICATION OF VAR
MODEL
H0: Unit root/non stationary.
H1: Stationary.
(
Reject H0 if the ADF statistics
C value ( )
)< the critical

If stationary, then PRI ~ I(0); if no


then PRI ~I(n); n>0.

If non stationary, take first


PRI of
PRI
differences
PRI
as t 1
t PRI

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SPECIFICATION OF VAR
MODEL
2) Testing for cointegration

Using Johansen test (multiple equation).


Steps:

Testing the order of integration of the variables.


Setting the appropriate lag length of the model.
Choosing the appropriate model.
Determining the number of cointegrating vector.

Choose variables then Quick/Group


statistics/Johansen Cointegration
test/OK
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SPECIFICATION OF VAR
MODEL
Step 1:Testing the order of integration
of the variables.
Step 2: Setting the appropriate lag
length of the model

Estimate VAR model including all variables in


levels
Inspect the values of the AIC, SBC and do
diagnostic checking (autocorrelation,
heteroscedasticity, normality, possible ARCH
effect).
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SPECIFICATION OF VAR
MODEL

VAR Estimation

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Normality Test
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Using the Jarque-Bera test for


normality.
It based on two measures:

Skewness refers to how symmetric


the residuals are around zero.
Kurtosis refers to the peakedness
of the distribution. For a normal
distribution, the kurtosis value is 3.
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Normality Test
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The Jarque-Bera statistics:


N
JB
6

3
2
S

where S = Skewness, K = Kurtosis, N =


Sample size
We reject the hypothesis of normally
distributed error if a calculated value of the
statistics exceeds a critical value selected
from the chi-squared distribution.
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SPECIFICATION OF VAR
MODEL

Step 3: Choosing the appropriate model


regarding the deterministic components in
the multivariate system.

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SPECIFICATION OF VAR
MODEL
Inform ation Criteria by Rank and Model
Data Trend:
Rank or
No. of CEs

None
No Intercept
No Trend

None
Intercept
No Trend

Linear
Intercept
No Trend

Linear
Intercept
Trend

0
1
2
3

Log Likelihood
-2412.003
-2400.054
-2393.478
-2392.300

by Rank (rows ) and Model (colum ns )


-2412.003
-2408.563
-2408.563
-2399.586
-2398.039
-2397.803
-2392.181
-2391.979
-2391.155
-2390.937
-2390.937
-2389.406

0
1
2
3

Akaike Inform ation Criteria by Rank (rows ) and Model (colum ns )


121.5001
121.5001
121.4782
121.4782
121.2434
121.2027
121.2293
121.2519
121.2901
121.0948*
121.1739
121.2091
121.2490
121.3077
121.2839
121.4150
121.4969
121.4969
121.5703
121.5703

0
1
2
3

Schwarz Criteria by Rank (rows ) and Model


122.2601
122.2601
122.3648
122.2160*
122.2848
122.3919
122.4405
122.5602
122.6423
122.9350
123.1435
123.1435

(colum ns )
122.3648
122.4724
122.7855
123.3436

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Quadratic
Intercept
Trend

-2400.869
-2391.895
-2389.677
-2389.406

122.2568
122.3614
122.8039
123.3436

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SPECIFICATION OF VAR
MODEL

of
Step 4: Determining the rank
or
the number of cointegrating vector.
Using two tests:

Eigenvalues (characteristic roots) test


H0

: Rank( ) = r (we have up to r


cointegrating relationship)
H1: (r + 1) vector.
Maximal eigenvalue statistic to test how
many of the number of the characteristic roots
are significantly different from zero.
max r , r 1 T ln 1 r 1

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SPECIFICATION OF VAR
MODEL

Using two tests:

Likelihood Ratio test


H0

: The number of cointegrating vectors is less


than of equal to r.
H1: The number of cointegrating vectors is more
than r.
Trace statistic:
n

trace r T ln 1
r 1
i r 1

If

trace statistic is smaller than the 5% critical


value; so the model does not show cointegration.
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SPECIFICATION OF VAR
MODEL
Unres tricted Cointegration Rank Tes t (Trace)
Hypothes ized
No. of CE(s )
None *
At m os t 1 *
At m os t 2

Eigenvalue

Trace
Statis tic

0.05
Critical Value

Prob.**

0.449779
0.280235
0.057191

39.40629
15.50888
2.355655

24.27596
12.32090
4.129906

0.0003
0.0141
0.1474

Trace tes t indicates 2 cointegrating eqn(s ) at the 0.05 level


* denotes rejection of the hypothes is at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values
Unres tricted Cointegration Rank Tes t (Maxim um Eigenvalue)
Hypothes ized
No. of CE(s )
None *
At m os t 1 *
At m os t 2

Eigenvalue

Max-Eigen
Statis tic

0.05
Critical Value

Prob.**

0.449779
0.280235
0.057191

23.89741
13.15323
2.355655

17.79730
11.22480
4.129906

0.0053
0.0226
0.1474

Max-eigenvalue tes t indicates 2 cointegrating eqn(s ) at the 0.05 level


* denotes rejection of the hypothes is at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values

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SPECIFICATION OF VAR
MODEL
Both the trace and the maximal
eigenvalue statistics suggest the
existence of two cointegrating
vectors.
Eviews then reports results regarding
the coefficients of the speed of

adjustment coefficients
( ) and the
matrix of the long-run
coefficients
( ).

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SPECIFICATION OF VAR
MODEL

After establishing the number of


cointegrating vectors, we
proceed with the estimation of
the ECM.

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VECM MODEL
ESTIMATION

If there is cointegration, we can


estimate the VECM.

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VECM MODEL
ESTIMATION
Cointegrating Eq:

CointEq1

REXP_M(-1)

1.000000

RFDI_M(-1)

-10.52989
(10.3874)
[-1.01372]

RGDP_M(-1)

-0.019252
(0.00352)
[-5.47628]

Error Correction:

D(REXP_M)

D(RFDI_M)

D(RGDP_M)

CointEq1

-0.039037
(0.01669)
[-2.33941]

-0.011229
(0.00529)
[-2.12306]

-4.457555
(0.95264)
[-4.67917]

D(REXP_M(-1))

0.457965
(0.18590)
[ 2.46349]

-0.026410
(0.05892)
[-0.44823]

7.924660
(10.6129)
[ 0.74670]

D(RFDI_M(-1))

-0.831488
(0.63688)
[-1.30557]

-0.043661
(0.20186)
[-0.21629]

-3.312521
(36.3589)
[-0.09111]

D(RGDP_M(-1))

-0.005673
(0.00410)
[-1.38363]

-0.002730
(0.00130)
[-2.10112]

-0.242330
(0.23406)
[-1.03532]

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VAR MODEL ESTIMATION


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If there is no evidence of cointegration, we


can estimate the unrestricted VAR.

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