Function

❑ Introduction
❑ Causes of
❑ Autocorrelation OLS
❑ Estimation
BLUE Estimator
❑ Consequences of using
❑ OLS Detecting
Autocorrelation
1. Introduction
❑Autocorrelation occurs in time-series
studies when the errors associated with a
given time period carry over into future
time periods.
❑For example, if we are predicting the growth
of stock dividends, an overestimate in one
year is likely to lead to overestimates in
succeeding years.
1. Introduction
❑Times series data follow a natural
ordering over time.

❑It is likely that such data exhibit

intercorrelation, especially if the time
interval between successive observations
is short, such as weeks or days.
1.
Introduction
❑We expect stock market prices to move or
move down for several days in
succession.
❑In situation like this, the assumption of no
auto or serial correlation in the error term that
underlies the CLRM will be violated.
❑We experience autocorrelation when
E(ui u j )  0
1. Introduction
❑Sometimes the term autocorrelation is used
interchangeably.
❑However, some authors prefer to distinguish between
them.
❑For example, Tintner defines autocorrelation as ‘lag
correlation of a given series within itself, lagged by a
number of times units’ whereas serial correlation is the
‘lag correlation between two different series’.
❑We will use both term simultaneously in this lecture.
1. Introduction
❑There are different types of serial correlation.
With first-order serial correlation, errors in
one time period are correlated directly with
errors in the ensuing time period.

❑With positive serial correlation, errors in one

time period are positively correlated with errors
in the next time period.
2. Causes of Autocorrelation
❑ Inertia - Macroeconomics data experience
cycles/business cycles.
❑ Specification Bias- Excluded variable
Appropriate equation:
Yt   1   2 X 2t   3 X 3t   4 X 4t  u t
Estimated equation
Yt  1   2 X 2t   3 X 3t  v t
Estimating the second equation implies
v t   4 X 4t  u t
2. Causes of Autocorrelation

❑ Specification Bias- Functional

Incorrect Form
Y   X  X2 
t
v
t 1 2 2t 3 2t

Yt   1   2 X 2t 
ut

u  X2 
t
v
t 3 2t
2. Causes of Autocorrelation

❑ Cobweb Phenomenon
In agricultural market, the supply reacts to
price with a lag of one time period because
supply decisions take time to implement. This
is known as the cobweb phenomenon.
Thus, at the beginning of this year’s planting
of crops, farmers are influenced by the price
prevailing last year.
2. Causes of Autocorrelation
❑ Lags
Consumptiont  1   2 Consumptiont 1
 uThe
t above equation is known as auto
regression because one of the explanatory
variables is the lagged value of the dependent
variable.
If you neglect the lagged the resulting error
term will reflect a systematic pattern due to the
influence of lagged consumption on current
consumption.
2. Causes of Autocorrelation

❑ Data Manipulation
Yt   1   2 X t  ut Yt 1   1   2 X t 1
u t 1

Yt   2 X t  v t
This equation is known as the first difference form
and dynamic regression model. The previous
equation is known as the level form.
Note that the error term in the first equation is not
auto correlated but it can be shown that the error
term in the first difference form is auto correlated.
2. Causes of Autocorrelation

❑ Nonstationarity
When dealing with time series data, we
should check whether the given time series
is stationary.
A time series is stationary if its characteristics
(e.g. mean, variance and covariance) are
time variant; that is, they do not change over
time.
If that is not the case, we have a non
stationary time series.
 Suppose Yt is related to X2t and X3t, but we
wrongfully do not include X3t in our model.

The effect of X3t will be captured by the

disturbances ut. If X3t like many economic series
exhibit a trend over time, then X3t depends on
X3t-1,X3t -2and so on. Similarly then ut depends
on ut-1, ut-2 and so on.
Suppose Yt is related to X2t with a quadratic
relationship:
Yt=β1+β2X22t+ut
but we wrongfully assume and estimate a straight
line:
Yt=β1+β2X2t+ut

Then the error term obtained from the straight line

will depend on X22t.
Suppose a company updates its inventory at a
given period in time.

If a systematic error occurred then the cumulative

inventory stock will exhibit accumulated
measurement errors.

These errors will show up as an auto correlated

procedure.
The simplest and most commonly observed is the
first-order autocorrelation.
Consider the multiple regression model:
Yt=β1+β2X2t+β3X3t+β4X4t+…+βkXkt+ut

in which the current observation of the error term

ut is a function of the previous (lagged)
observation of the error term:
ut=ρut-1+et
 The coefficient ρis called the first-order
autocorrelation coefficient and takes values
-1 to +1.
from
It is obvious that the size of ρ will
determine the strength of serial
correlation.

We can have three different cases

If ρ is zero, then we have no
autocorrelation. 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.
If ρ approaches -1, we have high degree
of negative 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
▶ The OLS estimators are still unbiased and
consistent.
This is because both unbiasedness and consistency
▶ do
Thenot
OLSdepend on assumption
estimators 6 which
will be inefficient andistherefore
in this case
violated.
no longer BLUE.
▶ 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.
 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:
❑ The Durbin Watson Test

❑ The Breusch-Godfrey Test

❑ Run test
 The following assumptions
should be satisfied:
❑ The regression model includes a
constant
❑ Autocorrelation is assumed to be of

first-order only
❑ The equation does not include a lagged

dependent variable as an explanatory

variable
▶ Step 1: Estimate the model by OLS and obtain
the residuals
▶ Step 2: Calculate the DW statistic
▶ Step 3: Construct the table with the calculated
DW statistic and the dU, dL, 4-dU and 4-dL
critical values.
▶ Step 4: Conclude
 It is a Lagrange Multiplier Test that resolves the
drawbacks of the DW test.
▶ Consider the model:
Yt=β1+β2X2t+β3X3t+β4X4t+…+βkXkt+ut
where:

ut=ρ1ut-1+ ρ2ut-2+ρ3ut-3 +…+ ρput-p

+et
▶ Combining those two we get:
Yt=β1+β2X2t+β3X3t+β4X4t+…
+βkXkt+
Serial Correlation Topic Nine
 The null and the alternative hypotheses are:

▶ H0:ρ1= ρ2=…= ρp=0 no autocorrelation

▶ Ha:at least one of the ρ’s is not zero, thus, autocorrelation

Step 1: Estimate the model and obtain the residuals

Step 2: Run the full LM model with the number of lags used
being determined by the assumed order of autocorrelation.
Step 3: Compute the LM statistic = (n-ρ)R2from the LM model
and compare it with the chi-square critical value.
Step 4: Conclude

Serial Correlation Topic Nine

 We have two different cases:
❑ When ρ is known
❑ When ρ is unknown

Consider the model

Yt=β1+β2X2t+β3X3t+β4X4t+…
+βkXkt+ut
where
ut=ρ1ut-1+et

Serial Correlation Topic Nine

❑ Write the model of t-1:

Yt-1=β1+β2X2t-1+β3X3t-1+β4X4t-1+…+βkXkt-1+ut-1
Multiply both sides by ρto get

ρYt-1= ρβ1+ ρβ2X2t-1+ ρβ3X3t-1+ ρβ4X4t-1

+…+ ρβkXkt-1+ ρut-1
❑ 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 Topic Nine
 Where now the problem of autocorrelation is
resolved because et is no longer
autocorrelated.
Note that because from the transformation
we lose one observation, in order to avoid
that loss we generate Y1 and Xi1 as follows:
Y*
X*1i1=Y
=X1i1sqrt(1- ρ22))
sqrt(1-ρ
This transformation is known as the quasi-
differencing or generalised differencing.
❑ 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.