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CHAPTER 21:

TIME SERIES ECONOMETRICS: SOME BASIC CONCEPTS

21.1

and variance are constant over time and if the value of the

covariance between two time periods depends only on the distance

or lag between the two periods and not the actual time at which the

covariance is computed.

21.2

stationary, it is integrated of order d, denoted as I (d). In its

undifferenced form, such a time series is nonstationary.

21.3

Loosely speaking, the term unit root means that a given time

series is nonstationary. More technically, the term refers to the

root of the polynomial in the lag operator.

21.4

21.5

series is stationary. The ADF is similar to DF except that it takes

into account the possible correlation in the error terms.

21.6

The EG and AEG tests are statistical procedures that can be used to

to determine if two time series are cointegrated.

21.7

relationship between them, even though individually each variable

is nonstationary. In that case the regression of one variable on the

other is not spurious.

21.8

Cointegration deals with the relationship among a group of

variables, where (unconditionally) each has a unit root.

21.9

variable(s), the resulting regression may pass the usual statistical

criteria (high R2 value, significant t ratios, etc.) even though a priori

we do not expect any relationship between the two. This is

especially so if the two variables are not cointegrated. However, if

the two variables are cointegrated, even though individually they

are nonstationary, then such a regression may not be spurious.

219

21.11 Most economic time series exhibit trends. If such trends are

perfectly predictable, we call them deterministic. If that is not case,

we call them stochastic. A nonstationary time series generally

exhibits a stochastic trend.

21.12 If a time series exhibits a deterministic trend, the residuals from

the regression of such a time series on the trend variable represents

what is called a trend-stationary process. If a time series is

nonstationary but becomes stationary after taking its first (or higher)

order differences, we call such a time series a difference-stationary

process.

21.13 A random walk is an example of a nonstationary process. If a

variable follows a random walk, it means its value today is equal to

its value in the previous time period plus a random shock (error

term). In such situations, we may not be able to forecast the course

of such a variable over time. Stock prices or exchange rates are

typical examples of the random walk phenomenon.

21.14 This is true. The proof is given in the chapter.

21.15 Cointegration implies a long term, or equilibrium, relationship

between two (or more variables). In the short run, however, there

may be disequilibrium between the two. The ECM brings the two

variables back to long term equilibrium.

Empirical Exercises

21.16 (a) The correlograms for all these time series very much resemble

the log GDP correlogram given in Fig. 21.8. All these correlograms

suggest that these time series are nonstationary.

21.17 The regression results are as follows:

log PCEt = 0.1899 + 0.0002t 0.0261 log PCEt 1

= (1.80)

(1.67)

(1.71)*

R 2 = 0.0144

*In absolute terms, this tau value is less than the critical tau value,

suggesting that there is a unit root in the log PCE time series, that is,

this time series is nonstationary.

220

= (1.41)

(1.15)

(1.29)*

R 2 = 0.017

* This tau value is not statistically significant, suggesting that the

log PDI time series contains a unit root, that is, it is nonstationary.

log Pr ofitst = 0.1412 + 0.0010t 0.0524 Pr ofits t-1

= (2.69)

(2.81)

(2.60)*

R 2 = 0.0354

* This tau value is not statistically significant, suggesting that this

time series has a unit root.

Dividends t = 0.0411 + 0.0004t 0.0180 Dividends t-1

= (2.09)

(1.61)

( 1.42)*

R 2 = 0.0217

* This tau value is not significant, suggesting that the

log Dividends time series is nonstationary.

Thus, we see that all the given time series are nonstationary. The

results of the Dickey-Fuller test with no trend and no trend and no

intercept did not alter the conclusion.

21.18 If the error terms in the model are serially correlated, ADF is the

more appropriate test. The statistics for the appropriate coefficient

from the ADF regressions for the three series are:

log PCE

-1.73

log DPI

-1.44

log Profits

-3.14

log Dividends

-1.42

The critical values remain the same as in Problem 21.17. Again,

the conclusion is the same, namely, that the three time series

are nonstationary.

21.19 (a) Probably yes, because individually the two time series

are nonstationary.

(b) The OLS regression of dividends on profits gave the following

results:

Variable

Coefficient

Std. Error

t-Statistic

C

-1.3339

0.0503

-26.50

PROFITS

1.1269

0.0103

109.63

R-squared

0.9803

d = 0.1509

221

root tests with no constant, constant, and constant and trend,

the results showed that the residuals were not stationary, thus

leading to the conclusion that dividends and profits are not

cointegrated. Since this is the case, the conclusion in (a) stays.

(c) There is little point in this exercise, as there is no long run

relationship between the two.

(d) They both exhibit stochastic trends, which is confirmed by

the unit root tests on each time series.

(e) If log Dividends and log Profits are cointegrated, it does not

matter which is the regressand and which is the regressor. Of

course, finance theory could resolve this matter.

21.20 The scattergrams of the first differences of log DPI, log Profits, and

log Dividends, all show diagrams similar to Fig. 21.9. In the first

difference form each of these time series is stationary. This can be

confirmed by the ADF test.

21.21 In theory there should not be an intercept in the model. But if there

was a trend term in the original model, then an intercept could be

included in the regression and the coefficient of that intercept term

will indicate the coefficient of the trend variable. This of course

assumes that the trend is deterministic and not stochastic.

To see this, we first regressed log Dividends on log Profits and the

trend variable, which gave the following results:

Dependent Variable: log DIVIDEND

Variable

C

Log PROFITS

trend

R-squared

Coefficient

0.4358

0.4245

0.0127

Std. Error

0.1053

0.0402

0.0007

t-Statistic

4.14

10.55

17.71

0.9914

assumes that there is a deterministic trend. But we know that the

dividend time series has a stochastic trend.

Now regressing the first differences of log Dividends on the first

differences of log Profits and the intercept, we get the following

results:

222

Variable

C

logProfits

R-squared

Coefficient

0.0193

0.0585

Std. Error

0.0021

0.0302

t-Statistic

9.24

1.94

0.01524

coefficient. The intercept value of 0.0193 is in theory equal to the

coefficient of the trend variable in the previous equation; the two

values are not identical because of rounding errors as well as the fact

that the trend in the dividends series is not deterministic.

This exercise shows that one should be very careful in including the

trend variable in a time series regression unless one is sure that the

trend is in fact deterministic. Of course, one can use the DF and

ADF tests to determine if the trend is stochastic or deterministic.

21.22 From the first difference regression given in the preceding exercise,

we can obtain the residuals of this regression ( ut ) and subject them

to unit root tests. We regressed ut on its own lagged value without

intercept, with intercept, and with intercept and trend. In each case

the null hypothesis was that these residuals are nonstationary, that is,

they contain a unit root test. The Dickey-Fuller values for the

three options were -17.05, -17.01, and -17.22. In each case the

hypothesis was rejected at 5% or better level (i.e., p value lower than

5%). In other words, although log Dividends and log Profits were

not cointegrated, they were cointegrated in the first difference form.

21.23 (a) Since is less than the critical value, it seems that the

housing start time series is nonstationary. Therefore, there is

a unit root in this time series.

(b) Ordinarily, an absolute t value of as much as 2.35 or greater

would be significant at the 5% level. But because of the unit

root situation, the true t value here is 2.95 and not 2.35. This

example shows why one has to be careful in using the t statistic

indiscriminately.

(c) Since the of X t 1 is much greater than the corresponding

critical value, we conclude that there is no second unit root in the

housing start time series.

223

21.25 (a) & (b)

40

20

0

0

500

1000

X

Y exhibits a linear trend, whereas X represents a quadratic

trend.

Here is the graph of the actual and fitted Y values:

40

20

5

0

-5

-10

10

Residual

20

30

Actual

Fitted

From the given regression results you might think that this

is a "good" regression in that it has a high R2 and significant

t ratios. But it is a totally spurious relationship, because we

are regressing a linearly trended variable (Y) on a quadratically

trended variable (X). That something is not right with this model

can be gleaned from the very low Durbin-Watson d value.

The point of this exercise is to warn us against reading too much in

the regression results of two deterministically trended variables with

divergent time paths.

21.26 (a) Regression (1) shows that the elasticity of M1 with respect to

GDP is about 1.60, which seems statistically significant, as the t

value of this coefficient is very high. But looking at the d value, we

224

regression is spurious.

(b) In the first difference form, there is still positive relationship

between the two variables, but now the elasticity coefficient has

dropped dramatically. Yes, the d values might suggest that there

is no serial correlation problem now. But the significant drop

in the elasticity coefficient suggests that the problem here may be

one of lack of cointegration between the two variables.

(c) & (d) From regression (3) it seems that the two variables are

cointegrated, for the 5% critical value is 1.9495 and the

estimated tau value is more negative than this. However, the 1%

critical tau value is 2.6227, suggesting that the two variables

are not cointegrated. If we allow for intercept and intercept and

trend in equation (3), then the DF test will show that the two

variables are not cointegrated.

(e) Equation (2) gives the short-run relationship between the logs

of money and GDP. The equation given here takes into account the

error correction mechanism (ECM), which tries to restore the

equilibrium in case the two variables veer from their long-run path.

However, the error term in this regression is not statistically

significant at the 5% level.

Since, as discussed in (c) and (d) above, the results of the

cointegration tests are rather mixed, it is hard to tell whether the

regression results presented in (1) are spurious or not.

21.27 (a) & (b) The time graph of CPI very much resembles Fig. 21.12.

This graph clearly shows that generally there is an upward trend in

the CPI. Therefore, regression (1) and (2) are not worth

considering. Note that the coefficient of the lagged CPI is positive

in both cases. For stationarity, we require this value to be negative.

Therefore, the more meaningful equation here is regression (3).

The DF unit root tests suggest that the CPI time series is

trend stationary. That is, the values of the CPI around its trend value

(which is statistically significant) are stationary.

(c) Since Equation (1) omits two variables, we have to use the

F test.

Using the R2 version of the F test, the R2 value of regression (1)

is 0.0703, which is the restricted R2. The R2 value of regression

(3), which is 0.507, is the unrestricted R2. Hence the F value is:

225

(0.507 0.0703) / 2

= 19.9305

(1 0.507) / 45

Referring to the DF F values given in Table D.7 in App. D, you can

see that the observed F value is highly significant (Note: The table

does not give the F value for 40 observations, but mentally

interpolating the given F values, you will reach this conclusion.).

Hence, the conclusion is that the restrictions imposed by regression

(1) are invalid. More positively, it is regression (3) that seems valid.

F=

226

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