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Chapter 07 - Autocorrelation
Chapter 07 - Autocorrelation
Applied Econometrics
Second edition
Dimitrios Asteriou and
Stephen G. Hall
Applied Econometrics: A Modern Approach using Eviews and Microfit © Dr D Asteriou
Applied Econometrics
AUTOCORRELATION
1. What is Autocorrelation
2. What Causes Autocorrelation
3. First and Higher Orders
4. Consequences of Autocorrelation
5. Detecting Autocorrelation
6. Resolving Autocorrelation
2
Applied Econometrics
Learning Objectives
1. Understand the meaning of autocorrelation in the CLRM.
2. Find out what causes autocorrelation.
3. Distinguish among first and higher orders of autocorrelation.
4. Understand the consequences of autocorrelation on OLS estimates.
5. Detect autocorrelation through graph inspection.
6. Detect autocorrelation through formal econometric tests.
7. Distinguish among the wide range of available tests for detecting
autocorrelation.
8. Perform autocorrelation tests using econometric software.
9. Resolve autocorrelation using econometric software.
Applied Econometrics
What is
What is Autocorrelation
Autocorrelation
Assumption 6 of the CLRM states that the
covariances and correlations between
different disturbances are all zero:
cov(ut, us)=0 for all t≠s
This assumption states that the disturbances ut
and us are independently distributed, which
is called serial independence.
Applied Econometrics
What is Autocorrelation
If this assumption is no longer valid, then the
disturbances are not pairwise independent, but
pairwise autocorrelated (or Serially Correlated).
This means that an error occurring at period t may be
carried over to the next period t+1.
Autocorrelation is most likely to occur in time series
data.
In cross-sectional we can change the arrangement of
the data without altering the results.
Applied Econometrics
First-Order Autocorrelation
The coefficient ρ is called the first-order
autocorrelation coefficient and takes values fom
-1 to +1.
First-Order Autocorrelation
(a) If ρ is zero, then we have no autocorrelation.
(b) If ρ approaches unity, the value of the previous
observation of the error becomes more important in
determining the value of the current error and therefore
high degree of autocorrelation exists. In this case we
have positive autocorrelation.
(c) If ρ approaches -1, we have high degree of negative
autocorrelation.
Applied Econometrics
First-Order Autocorrelation
Applied Econometrics
First-Order Autocorrelation
Applied Econometrics
Higher-Order Autocorrelation
Second-order when:
ut=ρ1ut-1+ ρ2ut-2+et
Third-order when
ut=ρ1ut-1+ ρ2ut-2+ρ3ut-3 +et
p-th order when:
ut=ρ1ut-1+ ρ2ut-2+ρ3ut-3 +…+ ρput-p +et
Applied Econometrics
Consequences of Autocorrelation
1. The OLS estimators are still unbiased and consistent. This
is because both unbiasedness and consistency do not
depend on assumption 6 which is in this case violated.
2. The OLS estimators will be inefficient and therefore no
longer BLUE.
3. The estimated variances of the regression coefficients will
be biased and inconsistent, and therefore hypothesis testing
is no longer valid. In most of the cases, the R2 will be
overestimated and the t-statistics will tend to be higher.
Applied Econometrics
Detecting Autocorrelation
There are two ways in general.
The first is the informal way which is done through graphs
and therefore we call it the graphical method.
The second is through formal tests for autocorrelation, like
the following ones:
Detecting Autocorrelation
Then we can store the residuals of this regression in a
vector by typing the command:
genr res01=resid
And a plot of the residuals can be obtained by:
plot res01
While a scatter of the residuals against their lagged
terms can be obtained by:
scat res01(-1) res01
Applied Econometrics
Detecting Autocorrelation
.12
.08
.04
.00
-.04
-.08
85 86 87 88 89 90 91 92 93
RES01
Applied Econometrics
Detecting Autocorrelation
.12
.08
.04
RES01
.00
-.04
-.08
-.08 -.04 .00 .04 .08 .12
RES01(-1)
Applied Econometrics
0 dL dU 2 4-dU 4-dL 4
Applied Econometrics
DW n
h 1
2 1 n 2
ˆ
1.658 37
1 1.2971
2 1 37 * 0.089 2
Applied Econometrics
Resolving Autocorrelation
We have two different cases:
Resolving Autocorrelation
(when ρ is known)
Consider the model
Yt=β1+β2X2t+β3X3t+β4X4t+…+βkXkt+ut
where
ut=ρ1ut-1+et
Applied Econometrics
Resolving Autocorrelation
(when ρ is known)
Write the model of t-1:
Yt-1=β1+β2X2t-1+β3X3t-1+β4X4t-1+…+βkXkt-1+ut-1
Multiply both sides by ρ to get
ρYt-1= ρβ1+ ρβ2X2t-1+ ρβ3X3t-1+ ρβ4X4t-1
+…+ ρ βkXkt-1+ ρut-1
Applied Econometrics
Resolving Autocorrelation
(when ρ is known)
Subtract those two equations:
Yt-ρYt-1= (1-ρ)β1+ β2(X2t-ρX2t-1)+ β3(X3t-ρX3t-1)+
+…+ βk(Xkt-ρXkt-1)+(ut-ρut-1)
or
Y*t= β*1+ β*2X*2t+ β*3X*3t+…+ β*kX*kt+et
Where now the problem of autocorrelation is resolved
because et is no longer autocorrelated.
Applied Econometrics
Resolving Autocorrelation
(when ρ is known)
Note that because from the transformation we lose
one observation, in order to avoid that loss we
generate Y1 and Xi1 as follows:
Y*1=Y1 sqrt(1- ρ2)
X*i1=Xi1 sqrt(1-ρ2)
This transformation is known as the quasi-
differencing or generalised differencing.
Applied Econometrics
Resolving Autocorrelation
(when ρ is unknown))
The Cochrane-Orcutt iterative procedure.
Step 1: Estimate the regression and obtain residuals
Step 2: Estimate ρ from regressing the residuals to its lagged
terms.
Step 3: Transform the original variables as starred variables
using the obtained from step 2.
Step 4: Run the regression again with the transformed
variables and obtain residuals.
Step 5 and on: Continue repeating steps 2 to 4 for several
rounds until (stopping rule) the estimates of from two
successive iterations differ by no more than some
preselected small value, such as 0.001.