Notes in ECOMET2

1. Review of Classical Linear Regression Model

Drivers: independent variable (right hand side)

 =  +   + 

 +   + 


Real world variable; 
stochastic or random variable

Under the condition of uncertainty, we have to expect errors.
Xs
exogenous fixed variable

 = 1, 2, 3, ..., n

 = intercept; value of Y when all Xs are zero

In matrix form,

=




 + 

( ) ( )

( )

Objective:

1. To find #" (problem of estimation)

2. To perform inferences on #" (problem of inference)


$(
) =  + % & & )*+

&'

, = - + % & & .*+

&'

&
marginal contribution of & to Y, ceteris paribus.

i.

i.
Do (statistical test) individual test
ii.
Joint (overall) test
iii.
Goodness of fit
/0 : & = 0 34 / : & (<, >, )0
j= 1, 2, 3, ... . k
Alternative hypothesis = operational statement of our research agenda
Basis of decision: p-value
true probability of incorrect rejection
9 < 0.05 <=>=?@ /0

ii.
iii.
iv.

/0 :  = 
= =  = 0 A 4 C3= DE@DF @E GE H@

/0 = )I-&J = & = -&K L = 1 O
j= 1, 2, ..., k

* : proportion of variation collectively explained Y by Xs
*P 
adjusted *  : remedy for loss of degrees of freedom

Degrees of freedom (df): number of observations left after estimation

Assumptions:
1)
2)
3)
4)
5)
6)

u is multivariate normal (MVN)

$() = 0
vanishing error expectation
$(QQ) = S  T (if zero)
autocorrelation
= S  variances homoscedasticity
$V W& X = 0 = exogeneity assumption os Xs
A has full rank and there is no maximum number of K; Xs should not be
correlated (non-multicollinearity)

If assumptions 1-6 are valid; by Gauss-Markov Theorem then OLS is BLUE

 Unbiased, consistent, sufficient, and efficient
Limited Dependent Variable Models
CLRM requires Y to be quantitative (continuous)

measure in interval or ratio scale
 Binary Response Models (Y is dummy)
 Differential intercept: right hand-side; dummy: left hand side
o LPM (Linear probability model)
o Logit model
o Probit model
 Multinomial Response Model (Y is multinomial)
 3 or more response categories
o Multinomial Logit model
o Multinomial Probit model
Nominal
scale of measurement
 Ordered Response Model (Y is ordinal)
o Ordered Logit model
o Ordered Probit model
 Censored Response Model
 (selectivity bias)

o Tobit model
o Heckit model
 Discrete Dependent Variable Models
o Count models
 Poisson model
 Negative binomial model
o Duration models

Binary Response Models

 =  + % & & + 
&'

 = 0 ^C_<= ;
= 1 4??=44 i=1, 2, 3, ..., n

) = Prb
 = 1| W , W
 , , W

The probability that success is attained

 LPM: OLS despite Y is dummy

Consequences: ), =
, (predicted probability)

ANCOVA
not all in the right hand side are dummy

ANOVA
all in the right hand side are dummy
 is not normal

Bernoulli
only 1-trial; violates normality






$( ) = )
mean error is not zero

3C<( ) = ) (1 ) )
heteroscedastic
*  is not reliable measure of goodnessof fit
), is not sure to fall within [0, 1]
e =  + &' & W& [index function]

Score of the ith observation(utility score)

*The bigger the z, the more probable the success
*The smaller the z, the more probable the failure
*new graph
i
) = gjk
^(@)G@ where f(t) is the link function
As z becomes smaller, p is also becoming smaller

Logistic Model- logistic distribution cumulative distribution function

Logistic Link (probability distribution function)
^(@) =

l mn

(ol mn )p

; |t|< =>will result in Logit Model

Standard Normal Link (t~(N(0,1)

^(@) =

r

i
) = gjk

mnp
p ; |t| <

l mn

(ol mn )p

Let u=1 + = jt
du= = jt G@

) =

=1

ol mui
l ui

= ) =

l ui vw

i
= -gjk
Kp

) =

sK

l uivw

xi

jxi

= = hi

=  + &' & W& + 

z
jx

= ln y

xi

{ = logit(natural logarithm of odds ratio[ratio of success probability/failure probability]

Odds ratio also measures the probability that Y=1 relative to the probability that Y=0
Estimation using Maximum Likelihood Estimation
-estimating the betas(parameters) in such a way that the likelihood of the
sample(joint probability) is maximized
1. get 1st derivative of the likelihood function
2. get 2nd derivative for it to be maximized. Hessian needs to be negative

{ = - + &' & W& sample regression function

e- = { by maximum likelihood estimation
*test of joint hypothesis using F-statistic

Binary Response Models

Y=0,1 [failure,success]
e- = - + &' & W& [index function]
) = )| b
= 1|e ]- probability that success is attained
LPM( OLS) Y is dummy
Logit( Logistic Link)
Probit(Standard Normal Link)

*Link function is a probability distribution function which will link the index from ~ to
[0,1]
Logistic pdf for the logit model
hi

) =  ^(@)G@
jk

^(@) =

l mn

(ol mn )p

where < @ <

) =
(Logit Model)
ol ui
l ui

)
_D
= - + % & W&
1 )
&'

The logit of the individual is the linear function of the individuals characteristics
 Solved via MLE (theres already an estimation)


{ = - + % & W& = e-

&'

Estimated logit is the linear function of the individuals characteristics

Used in forecasting:
^ ) 0.05; success ->
, = 1
^ ) 0.05; failure->
, = 1
xi

=marginal contribution of W& to ) , ceteris paribus[(k-i)n]

We will be able to determine the role of success factor of the ith individuals
x
y i z = - + &' & W& (Implicit Function of Differentiation)
jxi

1 )

)

(1 ))

)
)
)  (1)
W&
W&
= &
(1 ) )

)
)
)
= & ) (1 ) )
W&
W&

)
= & ) (1 ) ); > = 2,3, , 1,2,3, D C<FDC_ =^^=?@4
W&
Probit Model- Standard Normal Cumulative Distribution Function
Link Function:

^(@) =

r

mnp
p

; < @ <

The the score, the the probability of success

*The slope gives the change in probability given a unit change in X.(not constant slope)

Loans approved not depending on default

) = V + &'(& W&) X; probit model where ) is the area under the normal curve


Use MLE to estimate the Betas

e- = - + % & W&
&'

), = (e- ) ; i=1,2, .n

xi

Marginal Effects =

Censored Regression Model

)
~
1 jhi p

=
= 
W& W&
2
),
= ^(e- )

W&

Tobit Model(James Tobin)

Model:

 = - + &' & W& ++ ; i=1,2,3 n

D = D + D where:
D with observations of both Y and xs
D with observations only on the xs (Censored sample)
E.g. amount spent on a car by ith family is linearly dependent on the socio economic status
of the family (W& =jth socio economic variable)
-> OLS will result in Biased and inconsistent estimates
Bias= sample selectivity bias- solution is the procedure developed by James tobin via
sampling from censored normal distribution.
*wage of workers= censored variable
-major substitute for OLS
Given: V
 , ,  X; i=1,2n
O = ; marginal density function of the Y and xs with respect to Y.
FOC:


# =0 {=1,2,..k}

-& =f(sample) j=1,2,..k

SOC:


# p

< 0 ; Hessian

Heckit Model: James Heckman

-alternative to the tobit model in addressing the selectivity bias of censored sample
Two stage process:
1. Selection stage: implementation of probit model
e = 0,1 (no, yes)
Index function is the probit model
e- for each i.
2. Consumption stage :  = - + &' & W& + where

(,i )
(,i )

lt tl ts|s | K|l

|l Ksl| tl | K|l

Truncated Regression Models

Ve- X
= D3=<4= __4 <C@E
Ve- X

No observation in Y= no observation in the Xs; truncated-effectively taken out from the

selection process.
Element of a random selection= inference
MLE via Sample Selection from Truncated Normal
Multinomial Logit Model
 = >; j=1,2,3.. m
) = )b
 = >|  ,
, . .  ; j=1,2 , .m-1(to avoid dummy variable trap)
-Link between the Xs and probability of 0 to 1.
Link: e& =  + &'  W&
Link function is the logistic distribution
Link function for MLM

) (&) = omw l{h ()} where j=1,2, ..m-1

l{h () }

) () = omw l{h ()}; base category

l{h () }

Relative risk ratio=

xi ()

xi ()

= = (w op

-The probability of being in the jth category with respect to the RRR reference/ base
category

Panel Data Econometric Models

This represents real world phenomena(data in two dimensions)
Panel Data
combination of cross section and time-series data.

t = @t time series observation for the ith individual on Y variable
i
space dimension indicating microunits
t
time dimension period in which Y is observed(behaves like time-series)
e.g. effect of education in income with data across individuals
i=1,2,3,.n
t=1,2,3,T
unbalanced panel=missing observation
Advantages of Using panel data
1. It allows us to account for unobserved heterogeneity (or
effects)of cross section or time series observational units
which when neglected will result in, OBV(Omitted Variable
Bias
2. more information, more variability, more degrees of freedom,
less collinearity and more efficiency
3. allows us to be able to model they dynamics of
change(structural change)
4. to have basis for modelling more sophisticated phenomena
which pure CS or TS models cannot perform.
5. to mitigate aggregation bias
Panel Data Models
1. Fixed Effects Models
Assumption: effects are fixed parameters to be estimated
a. Naive model: all parameters are fixed (time and space invariant)

=  + &' & &t + t ; i=1,2n and t= 1,2. T
df=nT-k
b. LSDV Models
i)
Model 1: intercept is time invariant and slopes are fixed

t =  + % & &t + t

&'

 =o  ;  is the animal spirit(unobserved heterogeneity)

ii)

Model 2: intercept is varying and slopes are fixed

t = t + % & &t + t

&'

t =  + @; @ is the animal spirit of time period shock

iii)

Model 3: intercept varies and space and slopes are fixed

t = t + % & &t + t

&'

Where: t =  + @- for every time period there is one delta

iv)


Model 4: all parameters are time invariant, the slopes and intercepts vary
across individual microunits.

t =  + % & &t + t

&'

Simultaneous Equations Model (SEM)

-Economic models for econometric data determined by 2 or more economic relationships

multi equation model
- 1 equation per sector
- 1 sector will be represented by 1 endogenous variable
M sectors (or M endogenous varibales)
K presetermined variables (exogenous + lagged endogenous)

 = ^( , _CFF=G
, E@=<
) + Q
CLRM:
  ,
 , ,  ;  = 1,2,3, , D
SEM:
 4, _CFF=G
, E@=<
4 ;  = 1,2,3, , D

Notations: (time based) (t=1,2,3,,T) time series

1.
  t =DGEF=DE4 3C<C_=
(m endogenoud var in SEM)
2. predetermined variables (x)
2 types:
1. truly endogenous variable

2. lagged ys
k-> predetermined variables

1



for i=1


t + t = Qt
 W

t W1
W
t W1
Qt W1
, = 4@<?@<C_ 9C<C=@=<4




t
1
+


t


t
Qt

=

t
Qt

t + 
t + + 
t +  t +  t + +  t = Qt

Simultaneous bias (SB)

-use of OLS when RHV include Ys

-OLS is biased and inconsistent

t + t = Qt

t 3=?@E< E^ =DGEF=DE4 3C<C_=4
# E^ =DGEF=DE4 3C<C_=4 D .$
t 3=?@E< E^ 9<=G=@=<D=G 3C<C_=4
# E^ 9<=G=@=<D=G 3C<C_=4
Simultaneous Bias -> OLS is inconsistent in the presence of endogenous variables at
RHV

t = t + t
OLS is BLUE for RFM

problem of identification
per equation:

= j ; t = j t

& =


C@ @  = 1,2, . . D; > = 1,2, . .
&

how can we recover the Bs and 4 from the 4? "

 states of identifiability on an equation
o exactly identified (unique solution)
o over identified (multiple solution)
o unidentified (no solution)
Conditions of identifiability

- order condition (necessary)

- rank condition (necessary and sufficient)
Order condition
an equation is identifiable if the number of excluded variables from it is atleast one less than the
number of endogenous variable in the SEM

Nationally,
M- # of endogenous var in SEM
K- # of predetermined in SEM
m- # of endogenous variables in the equation
k- # or predetermined variables in the equation
(M+K) (m-k) 1

K-km-1
> over
= exact

Rank condition
an equation is identifiable if and only if there exsist atleast one subdeterminant (M-1) (m-1)
formed by the coefficients of the variable exclude from the equation evaluated.
L. Klein Close Economy Basic Model

equations: Structural model
1.
2.
3.
4.
5.

t = C + 
t + ? t + G *t + t (consumption function)
Tt = C + 
t + ? *t + t (investment function)

t = ?t + Tt + t (Identity)
t = C
+

t +
*t + G
)t + 
t (Liquidity preference)

t = O + t + t (production function)

6. t = C + Ht + ? )t + t ( Labor demand function)

7. t = C + Ht + ? )t + t (labor supply function)

Standard form:

t + ) t = t
t = t + 3t

Identification issue: how are we going to retrieve the s and s from the s?

Maddala System
Included = 1
Excluded = 0
Eqn#
1
2
3
4
5
6
7

C
1
0
1
0
0
0
0

I
0
1
1
0
0
0
0

N
0
0
0
0
1
1
1

P
0
0
0
1
0
1
1

R
1
1
0
1
0
0
0

Y
1
1
1
1
1
0
0

W
0
0
0
0
0
1
1

G
0
0
1
0
0
0
0

T
1
0
0
0
0
0
0

M
0
0
0
1
0
0
0

K-k
2
3
2
2
3
3
3

m-1
2
2
2
2
1
2
2

Status
Exact
Over
Exact
Exact
Over
Over
Over

K
number of predetermined variables

k
number of included predetermined variables
m
number of included endogenous variables

Identity: no coefficient; no problem

Status should be exact
All identification equations are almost exact
An equation is identified if and only if there exist at least one non-singular m-1 by m-1
sub-matrix form out of coefficients of the variable excluded in other equations.
Rank Condition
This is not equal to zero = non-singular

It is singular if there is a row or column that is filled of all zeros.

Via Laplace expansion

1
1

0
0
0

Hausman test for:

0
0
0
1
1
1

0 0
0 0
1 0
0 0
1 1
1 1

0
1
0
0
0
0

0
0

0
0
0

Simultaneity
Exogeneity

Hausman test for Simultaneity

t =  +  t + 

t + t

Step 1: Get the reduced form residuals of


t = O + O t + 3t

3t = *+ <=4GC_ E^


Step 2: Augment the original model by 3t

If - is significant


t =  +  t + 

t +  3t + t

Reject /0 :  = 0

OLS can still be used despite
t (=DGEF=DE4) variables at RHS.

Hausman test for Exogeneity

Step 1: Get the fitted value (
,) of the endogenous variable at right hand side

,t and augment the original model +

,

t + t
Kl tjtlt

If there are many restrictions
Walds test

Simultaneous Equation Method

-at this point the equations in the system are identified
2 approached of solving structural SEM
1. Full information (aka System Approach)

-estimating all parameters in the SEM in one fell swoop

-all equations solved together simultaneously
risky proportions (solving the entire system)unpopular
- any specification errors in one equation of the system will be transmitted in the entire
system (contagious)
o OVB
o Wrong functional form
o Non normality of the error etc.
- Only do this if you have very high confidence in your model
Among techniques include:
1. full information maximum likelihood (FIML)
you cant formulate the likelihood formula because of some peculiarities (sometimes)
due to transmission errors
2. 3SLS (3 stage least squares)
3 dimentional model (L W H)
rarely used
3. seemingly unrelated regression (SURE)
errors of equations are contemporaneously correlated
multiple equations solving technique
4. joint generalized least squared (JGLS)
SEM version of GLS

2. Limited information (aka single equation approach)

a. Solve one eqation after the other
b. Not susceptible to another equation
c. Specification error confined with one equation only
Techniques used:
1. OLS
a. When systems are recursive
b. OLS is BLUE
c. Maligned to be avoided
Whenever b is triangular
1
0 0
B=  1 0


 1
Matrix of endogenous variable coefficients
Eg.
t = C _(hl| llt)_ + = t + ^ t + Qt

t = C + 
t + = t + ^ t + Qt


t = C
+

t +

t +
t + ^
t + Q
t
{
t } {Qt }
{ h , t } {
t } {Qt }

 {

t } {Q
t }

2. ILS (indirect least squares)

a. Applicable on exactly identified equations
b. Mathematical solution exploit one to one correspondence on 4 CDG 4
3. Limited information maximum likelihood
a. Single equation counterpart of FIML
4. 2SLS
a. best thing that happened to SEM
b. henry theil Robert bassman
Stage1: 4 G=@=<D=G 4DF <=G?=G ^E<
=3C_=D@ C@ */.
stage2: structural equation is determined with in the forst stage proxying for the
y at RHS.

Dynamic Econometric models

Models Concerned with the consequences of economic actions over time


.@C@?:
t =  + % & &t + t

&'

Dynamic: lapse of time before impact is felt

e.g. Y
target variable
X
proxy variable
When consequences are rarely instantaneous

1. DL(p)
distributed lag model

t = O + 0 t +  tj + +  tj + t
O
endowment (autonomous Y)
0
impact multiplier

intermediate multiplier
 = 1, 2, 3, , 9

t = O + %  tj + 
'0

  = D@=< _@9_=< = % &

&'0

 =  = {EDF <D _@9_=< (@E@C_ =^^=?@)

2. AR(q)
Autoregressive model

t = + % O&
tj& + t
&'0

t = + O
tj + O
tj + + O
tj + t

What you are today is a function of what you were before

3. ARDL (q, p)

t = + %  tj + % O&
tj& + t

'0

&'

What you are today is influenced by what you were before plus how the authorities molded you
to be how you are today
Focus: DL(p) model



Finite DL model (p is finite)

Infinite DL model (p
)

t = O + %  tj + t *(9)
'0

OLS: there are no endogenous at RHS (estimation method)

Alt-Tinbergen Method
o Sequential OLS
o Bottom-up
o Will start in simple regression up to complicated model
Hendry Top-down Method
o Will start in big model
o AIC (choose the model p* with smallest AIC

P
finite

Almon Model

Koyck model
 Adaptive Expectation
 Rational Expectation

Infinite DL Models

t = O + %  tj + t {(9)



Finite DL model (p is finite)

Infinite DL model (p
)

'0

 D@=<=GC@= _@9_=<  = 0,1, 2, 3, , 9

Koyck Model

t = O + 0 t +  tj + +  tj + + t
 = 0   = 0, 1,2, 3,

<C@= E^ G=?C (0 1)


1.
t = O + 0 t + 0 tj + 0  tj + + 0 tj
+ + t
D^D@= G4@<@3= _CF EG=_

Lag (1) by 1 period multiply the result by , subtract the outcome from (1)

t
tj = O (1
)

+ 0 t + t tj
lls
s&Ktlt

t = O(1 ) + 0 t +
tj + t tj

ARDL (1, 0)

Three issues:

Autocorrelation
Simultaneity bias
Non-linear in parameter

SEM
static/contemporaneous

t = O + 0 t +
tj + 3t


tj
is endogenous in dynamic model

O(1 )
non-linear in parameter

Durbin-watson cannot because of the presence of lag(1) on RHS,
tj .

We cannot use OLS.

Estimation of O , 0 & W: {. 4 E@!

Use 2 tests for Autocorrelation

Durbin h-test
presence/absence of autocorrelation

=

1 3C<V-X

; = 1

G
G = 4@C@4@?
2

Instrumental Variable/ Proxy Method



Liviathan Method

tj has to be proxied by tj

SRF:
,t = O + -0 t + -
tj

FOC:

- = -0 -

*.. = %(
t O
-0 t - tj )

t'

= 0
normal equation

  = D@=< _@9_=< ?_C@3= =^^=?@



 = % -&


&'0

  = 4 E^ 0 +  +  (?_C@3=)
p

 =  = {* _@9_=< @E@C_ =^^=?@

k

 = % -& ?_C@3= =^^=?@

&'0

-0
 = % -& =
= lim % -& D^D@= 4=<=4 ^D?@ED
k
1

&'0

&'0

Median Lag
amount of time lag (lapse of time) within 50% of total effect would be
manifested
Mean Lag
amount of time on the average, the total effect would be perceptible

Koyck Model

With  = 0  ;  = 0, 1, 2, 3,


ARDL (0,1)

Problems:

t = O + %  tj + t
'0

t = O + 0 t +
tj + 3t

1. O = O(1 )
2. 3t = t tj *(1)
3.
tj =DGEF=DE4

OLS is out because we cannot get BLUE due to these problems.

Estimation:
1. IV method of Liviatan
tj 9<EW=4 ^E<
tj
2. 2SLS
For autocorrelation: use Durbin h

Use large T for problem (1)
ALMON MODEL

t = O + %  tj + t
'0

9 = ^D@= (/=DG< @E9 GEHD)

 = O0 + % C&  t
&'

-mth degree polynomial

Jan Kmenta
-provided the ses to the SRF

- = C0 + % C&  &

&'

3C<V- X = % 3C<(C& ) + ?E3(C , C )  4

&'

Time series Econometrics



Basic Concepts
o Application of econometrics to TS data
o Data on variables captured and recorded in regular intervals of time (e.g. annual,
quarterly, monthly, etc.)
o Historical data-frequently/massively available

Challenges in using TS data in research









Autocorrelation
Spurious regression (non-sensical)
Random walk phenomenon
o Tomorrows stock market price, the best prediction is closing price today

random walk forecasting
ARCH effect (Autoregressive Conditional Heterescedasticity)
conditional volatility in
stock market
Forecasting
Non-stationarity of most variables

Stochastic process (SP)
collection of random variables ordered in time

e.g. {
t } @ = 1, 2, 3, ,
{
,
 , ,
}

DGP (Data Gathering Process)

 Unknown mechanism that generates realization for a SP
Realization
historical data (TS data)

{
t } {
t }

If {
t } is weakly stationary process, its first 2 moments are said to be time-invariant.
i.e. $(
t ) =

3C<(
t ) = $(
t ) = S 

?E3(
t ,
tj ) = $(
t )(
tj ) = 

If strongly stationary, time-invariant in all moments

 White noise most basic of all stationary SPs building block of all TS models, t
 Random walk most basic of all non-stationary stochastic processes,
t =
tj + t

t

tj

t||ls |

t
|s


= t

= t

tl
l

= G^^=<=D?DF E9=<C@E<;
= 1 {;

{ = _CF E9=<C@E< H@ ED= 9<E9=<@ {
t =
tj

t = t = (1 {)
t =
t {
t

t =
t

= (
t
tj )

=
t
tj (
tj
tj )

=
t 2
tj +
tj = (1 {)
t

Unit roots
number of times a SP say {
t } is to be differenced to make it stationary

i.e. If
t ~T(G) E<
t 4 D@=F<C@=G E^ E<G=< G

d
number of unit roots in
t

Integrated SPs

t ~T(0) 4@C@EDC<


t ~T(G); d
order of integration or # of unit roots in
t

1st difference of CPI is inflation


t = )Tt

t = TD^t

t = )Tt )Ttj

TD^t = TD^
TD^

t
tj
(0)

Random walks and White noise process

RWM

G = 0,1,2

t =
tj + t

t = t

3 types of Random Walks

1. RWM

t =
tj + t ; = 1

2. RWMD (with drift)

t =


+
tj + t ;
s|t
|ltl|

Kt||lt
llt

=1

3. RWDT (with deterministic trend)

t = +
tj + t + t ; = 1
When two or more NS variable are regressed, the result is spurious.

Granger-Newbold Rule (aka Classical)

symptom of spurious regression

If *  > <D HC@4ED 4@C@4@? 49<E4

Unit root testing

provided by Dickey and Fuller

Dickey-Fuller Test
Auxillary regression:

RWM:

t =
tj + t

t = (1 )
tj + t

t = O
tj + t

/0 : O = 0 =CD4 = 1 / : O < 0 (4@C@EDC<)

Derived from normal distribution

@=
Thats why they developed

O
DE@ 3C_G
4=(O)

 @C distribution (aka Dickey-fuller distribution)

Shortcoming:
t = O
tj + t

t is highly correlated but Dickey and fuller assumed that it is white noise.

Augmented Dickey-Fuller Test (ADF)

RWM:

t =
tj + % 
tj + t
'

RWMD:

t = +
tj + % 
tj + t
'

RWMDT:

t = +
tj + t + % 
tj + t
'

Level series
original time series that were investigating

t ~*(9) current error has long memory; current is related to past

t =  tj +  tj + + tj + t

Alternative unit root tests: PP, KPSS, ADF-GLS, DP, NP

Cointegation Analysis
It is a property of 2 or more non-stationary variables to be linked together by a LR equilibrium
relationship
Robert engle and Clive Granger (1982)
 Work for cointegration analysis to check if theres spurious regression
Augmented Engle Granger Test (AEG)
If t ,
t ~T(0) if their SRF

, = - + - t ; t =

, ~T(0)

Then t CDG
t are cointegrated

Stage 1: ADF t CDG
t if both are I(1)

We perform unit root test on both variables and see to it that they are non-stationary.

Stage 2: Run OLS on t CDG
t to get SRF and obtain t , ADF t and if t ~T(0)
X & Y are
cointegrated
Short-run dynamics
ECM: Error Correction model
 Granger Representation Theorem
- If the variable used in regression are cointegrated, an ECM representation
of the LR model is possible.
In k=2:

t = O0 + O t + O tj + t

O =<<E< ?E<<=?@ED ?E=^^?=D@

Cointegration and Error correction
VAR(p)
Christopher Sims
Vector Autoregression
Let
tA = b
t
t
t

All variables are endogenous

As are matrices.

t = t + 
tj + 
tj +
tj + t

OLS per equation is BLUE

AR(p) current var is related to past value

j

t = t +
tj + % 
tj + t
'

Johansen

Eigen-value
max @=4@
individual test

trace test
cumulative testing

Identifiication of the cointegration vectors

Cointegrated vector
economic theory; long-run equation

= O
=
O




s&Ktlt tl|t
| l|||
lt|
tl|

Johansen
more versatile and can be used for more than two variables