CH 13

Chapter 13
Vector Error Correction and Vector

Autoregressive Models
Walter R. Paczkowski
Rutgers University
Chapter 13: Vector Error Correction and Vector
Principles of Econometrics, 4th Edition Page 1
Chapter Contents
 13.1 VEC and VAR Models

 13.2 Estimating a Vector Error Correction Model
 13.3 Estimating a VAR Model
 13.4 Impulse Responses and Variance

A priori, unless we have good reasons not to, we
could just as easily have assumed that yt is the
independent variable and xt is the dependent
variable
– Our models could be:
Eq. 13.1a yt  10  11 xt  ety , ety ~ N (0,  2y )
Eq. 13.1b xt  20  21 yt  etx , etx ~ N (0, 2x )

For Eq. 13.1a, we say that we have normalized on
y whereas for Eq. 13.1b we say that we have
normalized on x

We want to explore the causal relationship
between pairs of time-series variables
– We will discuss the vector error correction
(VEC) and vector autoregressive (VAR)
models

Terminology
– Univariate analysis examines a single data
series
– Bivariate analysis examines a pair of series
– The term vector indicates that we are
considering a number of series: two, three, or
more
• The term ‘‘vector’’ is a generalization of the
univariate and bivariate cases

13.1
VEC and VAR Models

13.1
VEC and VAR
Models
Consider the system of equations:

yt  10  11 yt 1  12 xt 1  vty
Eq. 13.2
xt  20  21 yt 1   22 xt 1  vtx
– Together the equations constitute a system
known as a vector autoregression (VAR)
• In this example, since the maximum lag is of
order 1, we have a VAR(1)

13.1
VEC and VAR
Models
If y and x are nonstationary I(1) and not

cointegrated, then we work with the first
differences:
yt  11yt 1  12 xt 1  vty
Eq. 13.3
xt  21yt 1  22 xt 1  vtx

13.1
VEC and VAR
Models
Consider two nonstationary variables yt and xt that

are integrated of order 1 so that:
Eq. 13.4 yt  0  1 xt  et

13.1
VEC and VAR
Models
The VEC model is:

yt  10  11 ( yt 1  0  1 xt 1 )  vty
Eq. 13.5a
xt   20   21 ( yt 1  0  1 xt 1 )  vtx
which we can expand as:
yt  10  (11  1) yt 1  110  111 xt 1  vty
Eq. 13.5b
xt   20   21 yt 1   210  ( 211  1) xt 1  vtx
The coefficients α11, α21 are known as error
correction coefficients
13.1
VEC and VAR
Models
Let’s consider the role of the intercept terms

– Collect all the intercept terms and rewrite
Eq. 13.5b as:
yt  (10  110 )  (11  1) yt 1  111xt 1  vty
Eq. 13.5c
xt  ( 20   210 )   21 yt 1  ( 211  1) xt 1  vtx

13.2
Estimating a Vector Error Correction
Model

13.2
Estimating a Vector
Error Correction
Model
There are many econometric methods to estimate

the error correction model
– A two step least squares procedure is:
• Use least squares to estimate the
cointegrating relationship and generate the
lagged residuals
• Use least squares to estimate the equations:
Eq. 13.6a yt  10  11eˆt 1  vty

Eq. 13.6b xt   20   21eˆt 1  vtx

13.2
Estimating a Vector
Error Correction FIGURE 13.1 Real gross domestic products (GDP = 100 in 2000)
Model
13.2.1
Example

13.2
Estimating a Vector
Error Correction
Model
To check for cointegration we obtain the fitted

equation (the intercept term is omitted because it
has no economic meaning):
Eq. 13.7 Aˆt  0.985U t
A formal unit root test is performed and the
estimated unit root test equation is:
 eˆ  .128eˆ
 t t 1
Eq. 13.8
(tau ) (  2.889)

13.2
Estimating a Vector
Error Correction FIGURE 13.2 Residuals derived from the cointegrating relationship
Model

13.2
Estimating a Vector
Error Correction
Model
The estimated VEC model for {At, Ut} is:

 A  0.492  0.099eˆ
 t t 1
(t ) (2.077)
Eq. 13.9
 U  0.510  0.030eˆ
 t t 1
(t ) (0.789)

13.3
Estimating a VAR Model

13.3
Estimating a VAR
Model
The VEC is a multivariate dynamic model that

incorporates a cointegrating equation
We now ask: what should we do if we are
interested in the interdependencies between y and
x, but they are not cointegrated?

13.3
Estimating a VAR FIGURE 13.3 Real personal disposable income and real personal
Model consumption expenditure (in logarithms)

13.3
Estimating a VAR
Model
The test for cointegration for the case normalized

on C is:
eˆt  Ct  0.404  1.035Yt
Eq. 13.10
eˆt  0.088eˆt 1  0.299Δeˆt 1
(tau ) (  2.873)
– This is a Case 2 since the cointegrating
relationship contains an intercept term

13.3
Estimating a VAR
Model
For illustrative purposes, the order of lag in this

example has been restricted to one
– In general, we should test for the significance
of lag terms greater than one
– The results are:
Eq. 13.11a
ΔCˆt  0.005  0.215ΔCt 1  0.149ΔYt 1
 t   6.969   2.884   2.587 
ΔYˆt  0.006  0.475ΔCt 1  0.217ΔYt 1
Eq. 13.11b
 t   6.122   4.885   2.889 
13.4
Impulse Responses and Variance
Decompositions

13.4
Impulse Responses
and Variance
Decompositions
Impulse response functions and variance

decompositions are techniques that are used by
macroeconometricians to analyze problems such
as the effect of an oil price shock on inflation and
GDP growth, and the effect of a change in
monetary policy on the economy

13.4
Impulse Responses
and Variance
Decompositions
13.4.1
Impulse Response
Functions
Impulse response functions show the effects of

shocks on the adjustment path of the variables

13.4
Impulse Responses
and Variance
Decompositions
13.4.1a
The Univariate Case Consider a univariate series: yt = ρyt-1 + vt
– The series is subject to a shock of size v in
period 1
– At time t = 1 following the shock, the value of y
in period 1 and subsequent periods will be:
t  1, y1  y0  v1  v
t  2, y2  y1  v
t  3, y3  y2  (y1 )  2 v
...
the shock is v, v, 2 v,
13.4
Impulse Responses
and Variance
Decompositions
13.4.1a
The Univariate Case
The values of the coefficients {1, ρ, ρ2, ...} are

known as multipliers and the time-path of y
following the shock is known as the impulse
response function

13.4
Impulse Responses FIGURE 13.4 Impulse responses for an AR(1) model yt = 0.9yt-1 + et
and Variance
Decompositions following a unit shock
13.4.1a
The Univariate Case

13.4
Impulse Responses
and Variance
Decompositions
13.4.1b
The Bivariate Case
Consider an impulse response function analysis

with two time series based on a bivariate VAR
system of stationary variables:
yt  10  11 yt 1  12 xt 1  vty
Eq. 13.12
xt  20  21 yt 1   22 xt 1  vtx

13.4
Impulse Responses
and Variance
Decompositions
13.4.1b
The Bivariate Case
The mechanics of generating impulse responses in

a system is complicated by the facts that:
1. one has to allow for interdependent dynamics
(the multivariate analog of generating the
multipliers)
2. one has to identify the correct shock from
unobservable data
Together, these two complications lead to what is
known as the identification problem

13.4
Impulse Responses
and Variance
Decompositions
13.4.1b
The Bivariate Case
Consider the case when there is a one–standard

deviation shock (alternatively called an
innovation) to y:

13.4
Impulse Responses
and Variance
Decompositions
13.4.1b
The Bivariate Case
Let v1 y   y , vty  0 for t  1, vt x  0 for all t:
t 1 y1  v1y   y
x1  v1x  0
t2 y2  11 y1  12 x1  11 y  12 0  11 y
x2  21 y1  22 x1  21 y   22 0   21 y
t  3 y3  11 y2  12 x2  1111 y  12  21 y
x3  21 y2  22 x2  2111 y   22 21 y
...
impulse response to y on y:  y {1, 11 ,  1111  12 21  ,}
impulse response to y on x:  y {0,  21 ,  2111   22 21  ,}
13.4
Impulse Responses
and Variance FIGURE 13.5 Impulse responses to standard deviation shock
Decompositions
13.4.1b
The Bivariate Case

13.4
Impulse Responses
and Variance
Decompositions
13.4.1b
The Bivariate Case
Now let v1x   x , vtx  0 for t  1, vty  0 for all t:

t 1 y1  v1y  0
x1  vtx   x
t2 y2  11 y1  12 x1  11 0  12  x  12  x
x2   21 y1  22 x1  21 0  22  x  22  x
...
impulse response to x on y:  x {0, 12 ,  1112  12 22  ,}
impulse response to x on x:  x {1, 22 ,   2112   22 22  ,}

13.4
Impulse Responses
and Variance
Decompositions
13.4.2
Forecast Error
Variance
Decompositions
Another way to disentangle the effects of various

shocks is to consider the contribution of each type
of shock to the forecast error variance

13.4
Impulse Responses
and Variance
Decompositions
13.4.2a
Univariate Analysis Consider a univariate series: yt = ρyt-1 + vt
– The best one-step-ahead forecast (alternatively
the forecast one period ahead) is:
yt  yt 1  vt
ytF1  Et [yt  vt 1 ]
yt 1  Et [ yt 1 ]  yt 1  yt  vt 1
ytF 2  Et [yt 1  vt  2 ]  Et [(yt  vt 1 )  vt  2 ]   2 yt
yt  2  Et [ yt  2 ]  yt  2  2 yt  vt 1  vt  2

13.4
Impulse Responses
and Variance
Decompositions
13.4.2a
Univariate Analysis
In this univariate example, there is only one shock

that leads to a forecast error
– The forecast error variance is 100% due to its
own shock
– The exercise of attributing the source of the
variation in the forecast error is known as
variance decomposition

13.4
Impulse Responses
and Variance
Decompositions
13.4.2b
Bivariate Analysis We can perform a variance decomposition for our
special bivariate example where there is no
identification problem
– Ignoring the intercepts (since they are
constants), the one–step ahead forecasts are:
ytF1  Et [11 yt  12 xt  vty1 ]  11 yt  12 xt
xtF1  Et [ 21 yt   22 xt  vtx1 ]   21 yt   22 xt
FE1y  yt 1  Et [ yt 1 ]  vty1 ; var( FE1y )   2y
FE1x  xt 1  Et [ xt 1 ]  vtx1 ; var( FE1x )   2x

13.4
Impulse Responses
and Variance
Decompositions
13.4.2b
Bivariate Analysis
The two–step ahead forecast for y is:

ytF 2  Et [11 yt 1  12 xt 1  vty 2 ]
 Et [11  11 yt  12 xt  vty1   12  21 yt  22 xt  vtx1   vty 2 ]
 11  11 yt  12 xt   12   21 yt   22 xt 

13.4
Impulse Responses
and Variance
Decompositions
13.4.2b
Bivariate Analysis
The two–step ahead forecast for x is:

xtF 2  Et [21 yt 1  22 xt 1  vtx 2 ]
 Et [21 (11 yt  12 xt  vty1 )  22 (21 yt   22 xt  vtx1 )  vtx 2 ]
  21 (11 yt  12 xt )   22 ( 21 yt   22 xt )

13.4
Impulse Responses
and Variance
Decompositions
13.4.2b
Bivariate Analysis
The corresponding two-step-ahead forecast errors

and variances are:
FE2y  yt  2  Et [ yt  2 ]  [11vty1  12vtx1  vty 2 ]
var( FE2y )  11 y  12

2 2 2
 2x   2y
FE2x  xt  2  Et [ xt  2 ]  [ 21vty1   22 vtx1  vtx 2 ]
var( FE2x )   221 2y   222  2x   2x

13.4
Impulse Responses
and Variance
Decompositions
13.4.2b
Bivariate Analysis
This decomposition is often expressed in

proportional terms
– The proportion of the two step forecast error
variance of y explained by its ‘‘own’’ shock is:
 11 y y 
 
2 2
  2
 11 y 12 x x 
 
2 2
  2
 2
  2
– The proportion of the two-step forecast error

variance of y explained by the ‘‘other’’ shock
is: 2 2
 2 2
12 x 
2 2

2
11  y  12 x   x 

13.4
Impulse Responses
and Variance
Decompositions
13.4.2b
Bivariate Analysis
Similarly, the proportion of the two-step forecast

error variance of x explained by its own shock is:
 22 x x 
 2
 2
  2
 21 y 22 x x 
 2
 2
  2
 2
  2
The proportion of the forecast error of x explained

by the other shock is:
 21 y 
 2
 2
 21 y 22 x x 
 2
 2
  2
 2
  2

13.4
Impulse Responses
and Variance
Decompositions
13.4.2c
The General Case
Contemporaneous interactions and correlated

errors complicate the identification of the nature
of shocks and hence the interpretation of the
impulses and decomposition of the causes of the
forecast error variance

Key Words

Keywords
dynamic impulse response

relationships functions
error correction VAR model
forecast error VEC model
variance
decomposition
identification
problem

Appendix

13A
The Identification
Problem
A bivariate dynamic system with

contemporaneous interactions (also known as a
structural model) is written as:
yt  1 xt  1 yt 1   2 xt 1  ety
Eq. 13A.1
xt  2 yt   3 yt 1   4 xt 1  etx
– In matrix terms:
 1 1   yt   1  2   yt 1  ety 
 1   x         x
 4   xt 1   et 
 2  t   3

13A
The Identification
Problem
More compactly, BYt = AYt-1 + Et where:
 yt  1 1   1 2  ety 
Y   B  A  E   x
 xt  2 1 3 4   et 

13A
The Identification
Problem
A VAR representation (also known as reduced-

form model) is written as:
yt  1 yt 1   2 xt 1  vty
Eq. 13A.2
xt  3 yt 1   4 xt 1  vtx

13A
The Identification
Problem
In matrix form, this is Yt = Cyt-1 + Vt where:
 1 2  vty 
C  V  x
 3 4   vt 

13A
The Identification
Problem
There is a relationship between Eq. 13A.1 and

Eq. 13A.2 with:
C  B 1 A, Vt  B 1 Et


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Chapter 13

Vector Error Correction and Vector

 13.1 VEC and VAR Models

Chapter 13: Vector Error Correction and Vector

Chapter 13: Vector Error Correction and Vector

Chapter 13: Vector Error Correction and Vector

Chapter 13: Vector Error Correction and Vector

Chapter 13: Vector Error Correction and Vector

Chapter 13: Vector Error Correction and Vector

Consider the system of equations:

Chapter 13: Vector Error Correction and Vector

If y and x are nonstationary I(1) and not

Chapter 13: Vector Error Correction and Vector

Consider two nonstationary variables yt and xt that

Chapter 13: Vector Error Correction and Vector

The VEC model is:

Let’s consider the role of the intercept terms

Chapter 13: Vector Error Correction and Vector

Chapter 13: Vector Error Correction and Vector

There are many econometric methods to estimate

Eq. 13.6a yt  10  11eˆt 1  vty

Chapter 13: Vector Error Correction and Vector

Chapter 13: Vector Error Correction and Vector

To check for cointegration we obtain the fitted

Chapter 13: Vector Error Correction and Vector

Chapter 13: Vector Error Correction and Vector

The estimated VEC model for {At, Ut} is:

Chapter 13: Vector Error Correction and Vector

Chapter 13: Vector Error Correction and Vector

The VEC is a multivariate dynamic model that

Chapter 13: Vector Error Correction and Vector

Chapter 13: Vector Error Correction and Vector

The test for cointegration for the case normalized

Chapter 13: Vector Error Correction and Vector

For illustrative purposes, the order of lag in this

Chapter 13: Vector Error Correction and Vector

Impulse response functions and variance

Chapter 13: Vector Error Correction and Vector

Impulse response functions show the effects of

Chapter 13: Vector Error Correction and Vector

The values of the coefficients {1, ρ, ρ2, ...} are

Chapter 13: Vector Error Correction and Vector

Chapter 13: Vector Error Correction and Vector

Consider an impulse response function analysis

Chapter 13: Vector Error Correction and Vector

The mechanics of generating impulse responses in

Chapter 13: Vector Error Correction and Vector

Consider the case when there is a one–standard

Chapter 13: Vector Error Correction and Vector

Chapter 13: Vector Error Correction and Vector

Now let v1x   x , vtx  0 for t  1, vty  0 for all t:

Chapter 13: Vector Error Correction and Vector

Another way to disentangle the effects of various

Chapter 13: Vector Error Correction and Vector

ytF 2  Et [yt 1  vt  2 ]  Et [(yt  vt 1 )  vt  2 ]   2 yt

Chapter 13: Vector Error Correction and Vector

In this univariate example, there is only one shock

Chapter 13: Vector Error Correction and Vector

FE1x  xt 1  Et [ xt 1 ]  vtx1 ; var( FE1x )   2x

The two–step ahead forecast for y is:

 Et [11  11 yt  12 xt  vty1   12  21 yt  22 xt  vtx1   vty 2 ]

 11  11 yt  12 xt   12   21 yt   22 xt 

Chapter 13: Vector Error Correction and Vector