Basic Econometrics, Gujarati and Porter

CHAPTER 21:
TIME SERIES ECONOMETRICS: SOME BASIC CONCEPTS

21.1

A stochastic process is said to be weakly stationary if its mean

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

If a time series has to be differenced d times before it becomes

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

It has to be differenced three times.

21.5

The DF test is a statistical test that can be used to determine if a time

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

Two variables are said to be cointegrated if there is a stable long-run

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

Tests of unit roots are performed on individual time series.

Cointegration deals with the relationship among a group of
variables, where (unconditionally) each has a unit root.

21.9

If a nonstationary variable is regressed on another nonstationary

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.

21.10 See the answer to the preceding question.

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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.

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log DPI t = 0.1235 + 0.0001t 0.0161log DPI t 1

= (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
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When the residuals from this regression were subjected to unit

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

But one should be wary of this regression because this regression

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:

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Variable
C
logProfits
R-squared

Coefficient
0.0193
0.0585

Std. Error
0.0021
0.0302

t-Statistic
9.24
1.94

0.01524

In this regression the intercept is significant, but not the slope

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.

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21.24 This is left for the reader.

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

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suspect that there is correlation in the error terms or that this

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:

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(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=

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