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AUTOCORRELATION

Reference: Chapter 10&12 of DNG

Multicollinearity

The theory of causation and multiple causation

Interdependence between the Independent Variables and

variability of Dependent Variables

Parsimony and Linear Regression

Theoretical consistency and Parsimony

X5

X4

Y X1

X3

X2

One of the assumptions of the CLRM is

that there is no Multicollinearity

amongst the explanatory variables.

Multicollinearity refers to perfect or

exact relationship among some or all

explanatory variables

Expl.: X1 X2 X* 2

10 50 52

15 75 75

18 90 97

24 120 129

30 150 152

X2i = 5X1i & X*2 was created by adding 2,

0, 7, 9 & 2 from, a random number table.

Here r1.2 = 1 & r2.2* = 0.99

X1 & X2 show perfect multicollinearity

X2 & X*2 near-perfect multicollinearity

The problem of multicollinearity and its

degree in types of data

Overlap between the variables

indicates the extent of it as shown in

the Venn diagram.

Example:

Y = a + b1x1 + b2x2 + u

where

Y = Consumption Expenditure

X1 = Income & X2 = Wealth

Consumption expenditure depends on income (x1) and

wealth (x2)

The estimated equation from a set of data is as follows:

= 24.77 + 0.94x1 0.04x2

t : (3.66) (1.14) (0.52)

R2 = 0.96 2 = 0.95 F = 92.40

The individual coefficients are not significant although F value

suggests a high degree of association

There is a wrong sign with x2

The fact that the F test is significant but the t

values of X1 and X2 are individually

insignificant means that the two variables are

so highly correlated that it is impossible to

isolate the individual impact of either income

or wealth on consumption.

Let us regress X2 on X1

X2 = 7.54 + 10.19 X1

t = (0.25) (62.04) R2 0.99

This shows near perfect multi-collinearity

between X2 and X1

Y on X1 Y on X2

= 24.24 + 0.51X1 = 24.41 + 0.05 X2

R2 = 0.96 R2 = 0.96

other variable significant.

Sources of Multicollinearity

Data collection method employed:

Sampling over a limited range of the values taken by

the regressors in the population

Constraints on the model or in the population being

sampled:

Regression of electricity consumption on income and

house size. There is a constraint : families with higher

income may have larger homes and hence more

electricity consumption.

Sources of Multicollinearity

Model specification:

Adding polynomial terms to a model when

range of X variable is small

An Over -determined Model:

This happens when the model has more

explanatory variables than the number of

observations.

Use of time series data:

Model share a common trend.

Practical Consequences of Multicollinearity:

In cases of near perfect or high multicollinearity one is

likely to encounter the following consequences:

variances making precise estimation difficult.

2. (a) Because of 1 the confidence intervals tend to be

much wider leading to the acceptance of the

zero null hypothesis (i.e. the true population

coefficient is zero) more readily.

(b) Because of 1 the t ratios of one or more

coefficients tend to be statistically insignificant.

Practical Consequences of Multicollinearity:

3. Although the t ratio(s) of one or more

coefficients is/are statistically insignificant, R2

the overall measure of goodness of fit, can be

very high.

sensitive to small changes in the data.

Detection of Multicollinearity

2. High pair wise correlation amongst regressors

(seen from correlation matrix)

3. Examination of partial correlation

4. Auxiliary Regressors and F-test (regress each xi

on remaining xis. Find F values and decide).

5. Eigen values and condition index.

Remedial Measures

1. A priori information and articulation

2. Dropping a highly collinear variable

3. Transformation of Data

4. Additional information or new data with

a priori reasoning

5. Identifying the purpose and reducing the

degree of it. (Or) Simply identifying it if

the purpose is prediction/forecasting.

AUTOCORRELATION

The assumption E(UU) = 2 I

Each u distribution has the same variance

(homoscedastic)

All disturbances are pair wise uncorrelated

This assumption gives

Var u1 Cov (U1 U2) ... Cov (U1, U2) 2 0 ... 0

Cov (U2 U1) Var V2 ... Cov (U2, Un) 0 2 ... 0

.... .... ... .... = ... ... ... ...

Cov (unU1) Cov(Un U2) ... (Var Un) 0 0 ... 2

E(UiUj) = 0 ij

This assumption when violated leads to:

1. Heteroscedasticity

2. Autocorrelation

Covariance is the measure of how much two

random variables vary together (as distinct from

variance, which measures how much a single

variable varies.)

Covariance between two random variables say X

and Y is defined as

Cov (X, Y) = E [(X - )(Y- )]

Where and are expected values of X and Y

respectively.

If X and Y are independent their cov. is Zero

The assumption implies that the disturbance

term relating to any observation is not

influenced by the disturbance term relating

to any other observation.

For example:

1. If we are dealing with quarterly time

series data involving the regression of the

following specification. (Time Series Data)

Output (Q) = f (Labour and Capital Input)

Q L K U

Q 1.1 L1 K1 U1

Q 1.2 L2 K2 U2

Output is Q 1.3 L3 K3 U3

There is no

affected Q 1.4 L4 K4 U4

reason to believe

due to Q 2.1 ... ... ... that this will be

labour ... ... ... ... carried over to

strike ... ... ... ... U4

... ... ... ...

Q n.4 L4n K4n U4n

2. Let

Family Consumption Expenditure = f (income)

(A regression involving Cross Section Data)

of Families Family

F1 I1 U1

F2 I2 U2

... ... ...

... ... ...

... ... ...

... ... ...

Fn In Un

The effect of an increase of one familys income on

consumption expenditure is not expected to affect the

consumption expenditure of another family.

The reality:

1. Distribution caused by strike may affect production

2.Consumption expenditure of one family may

influence that of another family i.e.

To keep up with the Joneses Demonstration effect

In cross section data it is referred to as spatial

autocorrelation.

Important Reasons for its occurrence (Time Series)

1. Inertia:

A salient feature of most economic series is inertia.

Time series data such as PCI, price indices, production,

profit, employment etc. exhibit cycles. Starting at the

bottom of a recession, when economic recovery

starts, most of these series move upward. In this

upswing the value of the series at one point of time is

greater than its previous value. Thus, there is a

momentum built into that an it continues until

something happens to slow them down.

[Intervention]

Therefore, in regression involving time series data

successive observations are likely to be inter-dependent

which reflect in a systematic pattern of the ui s.

2. Specification bias:

Excluded variable(s) or incorrect functional form.

a) When some relevant variables have been excluded

from the model they will reflect a systematic pattern

in the ui s.

b) In case of incorrect functional form i.e. fitting a linear

function when the true relationship is log-linear (&

vice-versa), there will either be over estimation or

under estimation of the dependent variable which will

have a systematic impact on Ui s.

Example:

(Correct) MC = 1 + 2 output + 3 (output)2 + Ui

(Incorrect) MC = b1 + b2 output + Vi

Where vi = (output)2 + ui and hence it will catch the

systematic effect of (output)2 on the MC leading to serial

correlation of uis.

3. Cobweb Phenomenon:

Supply of many agricultural commodities reflect the so

called Cobweb-Phenomenon where supply reacts to

price with lag of one time period because supply

decisions take time to implement (gestation period).

Expl. : At the beginning of this years planting of crops farmers

are influenced by the price prevailing last year.

Suppose at the end of period t price Pt turns out

to be lower than Pt-1. Therefore, in period t +1 the

farmer may decide to produce less than they did in

period t.

Such phenomena are known as Cobweb

Phenomena. And they give a systematic pattern to

the Uis.

In cases of Household Expenditure, share prices

etc. such problem arises. In general, when lagged

variable is not included (in many cases) the uis are

correlated.

4. Manipulation of time series data:

(i) Extrapolation of values of variables like

population give rise to serial dependence of

successive Uis.

(ii) Very often we use projected population figure

to arrive at per capita figure for any macro-

variable and use of such figures in forecasting

using regression (the successive Uis are serially

correlated).

Consequences: (Proofs are not given)

In the presence of autocorrelation in a model:

a) Residual variance is likely to under estimate

the true 2.

b) R2 is likely to be over estimated.

c) t test are not valid and if applied likely to give

misleading conclusions.

OLS estimators although linear and unbiased, they

do not have minimum variance leading to invalid

t and F test.

Detection of autocorrelation:

The assumption of the CLRM relates to the population

disturbance term which are not directly observable.

Therefore, their proxies i.e. is are obtained from OLS

and examined for the presence/absence of auto

correlation.

There are various methods. Some of them are:

1. Graphical Method

2. Runs Test (a non-parametric test) Examines the

signs

3. DW-statistics

Remedial Measures:

Data transformation by

a) First difference method (Xt+1 Xt) (one degree

of freedom is lost)

b) transformation

Estimated

(Yt - Yt-1) = 1(1- )+2(Xt- Xt-1)+ut

equation.

Exercise 3 ( Refer Ch 10&12 of DNG)

Use time series data in MR

Find Correlation table

See the extent of multicollinearity

Test for autocorrelation

In the presence of it use Ro transformation

Addressing both the problems calculate

forecast errors and select an equation which

gives the minimum forecast error.

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