ECONOMIC DATA ANALYSIS:

AUTOCORRELATION
AUTOCORRELATION
 Autocorrelation means that the error terms are lagged; that is, error terms are
influenced by the error terms in previous periods.
 This breaks one of the assumptions of OLS; namely that:
 Cov (eI, eJ) = 0
 The most common form of a lag is autocorrelation, as noted above, however
there may be lags in the actual variables as well.
 First – order Autoregressive lags (AR1) imply that the error terms are only
correlated for 1 period.
 We can model this as:
 Yt = B1 + B2Xt + et [Eq.1], where the model is AR(1)
 et = Pe(t-1) + Vt [Eq.2]; the error term depends on some weighting of the previous
error term plus a random error ‘V’. Assume ‘V’ to have all the assumptions we bestow
upon ‘e’ normally – homoskedasticity, no serial correlation, normality, expected value
of 0.
 Furthermore, assume |P| < 1.
 By modelling in this way, the properties of the AR(1) model are:
 Homoskedastic
 E(et) = 0
 Cov (et, e(t-k)) = σ2ePk ; this means that the corr (et, e(t-k)) = Pk ; hence, the
effect of previous periods diminishes the further back you go.
AUTOCORRELATION
 Sources of Autocorrelation:
 Inappropriate Functional Form.
 Omitted variables
 Incorrect Time Period
 Inappropriately filtered data (e.g seasonal adjustment)
 Effects of Autocorrelation (largely the same as Heteroskedasticity):
 OLS is still Linear and Unbiased, but it is no longer best.
 E.S.E are WRONG, hence you may not carry out hypothesis tests.
 The Road to The Generalized Least Squares Estimator:
 It is possible to calculate OLS e.s.e that are robust for AR(1), but as we know, they
will not necessarily be ‘Best’. Therefore we must concentrate on employing a better
estimation technique.
 Substitute Eq 2. into Eq 1.
 Yt = B1 + B2Xt + Pe(t-1) + Vt  We now need to eliminate ‘e(t-1)’.
 We achieve this by re arranging Eq 1 to get ‘et = Yt – B1 – B2Xt’, and then lagging by
one period and substituting into the above equation:
 Yt = B1 + B2Xt + P[Y(t-1) – B1 – B2X(t-1)] + Vt
 Yt – PY(t-1) = (1 – P)B1 + (Xt – PX(t-1))B2 + Vt
 This is the nonlinear least squares estimate; however, there are problems:
 LOSE THE FIRST OBSERVATION (variance is different for only that obs.)
 WE DO NOT KNOW WHAT ‘P’ IS.
AUTOCORRELATION
 Concerning the two problems:
 Estimating ‘P’:
 Simple enough, remember that et = Pe(t-1) + Vt
 Remember also that et = Yt –B1 – B2Xt, and that this could be lagged.
 Hence, substitute the latter into the former to get:
 Yt –B1 – B2Xt = P[Y(t-1) –B1 – B2X(t-1)] + Vt
 Apply Least Squares Estimation and bam, you get P.
 Recovering the first observation:
 The problem with the first observation is that it no longer has the same
variance as all the other observations.
 Hence, it can be seen as a special case of Heteroskedasticity.
 The variance is: Var(e1) = σ2e = (σ2v) / (1 – P2)
 Hence, it can be fixed by using weighted least squares
estimation; multiply the original equation by (1 – P2)½

1 .    Y  1     

2
1
2
1 1     
2
2 X1  1     e
2
1
AUTOCORRELATION
 Detecting Autocorrelation:
 3 Main tests (aside from graphical interpretation):
 Durbin – Watson
 Durbin – h Test
 LM Test

 Durbin – Watson:
 Distribution does not hold for lagged dependent variables.
 Assumes AR(1)
 The test statistic is approximately :
 d ≈ 2(1 – r), where ‘r’ is the estimated value of ‘P’.
 The Durbin – Watson distribution is on the next slide; however, it is
very difficult, and because of the approximation, there are upper and
lower bounds where we may accept or reject the null Hypothesis of no
autocorrelation (easier to use p – values; reject if P value <
significance level).
 When consulting the tables, ‘K’ is the number of explanatory variables
in the model.
AUTOCORRELATION: DURBIN –
WATSON BOUNDS TEST
H0: no positive H0*: no negative
autocorrelation autocorrelation

Reject H0 Zone of Zone of Reject H0*

Evidence of indecision indecision Evidence of
positive negative
auto-correlation Do not reject H0 or H0* or auto-
both. correlation

d
0 dL dU 2 4- du 4- dL 4
AUTOCORRELATION
 Durbin–h Test:
 In the case of a lagged dependent variable, one may use an
alternative test, proposed by Durbin:
 Lag the dependent variable, and then calculate the test statistic:

n
h
1  n   2i
 Where ‘sigma-squared beta-i’ is the variance of the parameter of the
lagged dependent variable.
 This test statistic is NORMALLY distributed, so the critical value
can be found using a ‘Z’ value (how odd).
 You can calculate ‘P’ by using the formula d = 2(1-P), and
substituting in the DW test stat (if given).
 You can calculate the variance by simply squaring the estimated
standard error.
 The test breaks down when n. Variance > 1, however.
AUTOCORRELATION
 Breusch-Godfrey LM test:
 Can be used for Autocorrelation greater than AR(1), and Lagged
dependent variables, so is the most ‘robust’.
 Calculated in a very similar fashion to the LM test for
Heteroskedasticity;
 LM = (n – k) x R2 ~ χ(1)
 Where ‘n-k’ is the number of sample observations – number of
explanatory variables.
 This arises because the LM test estimates the significance of lagged
residuals:
 Ut = Yt + c1U(t-1) + c2U(t-2) + ...
 It will test the null of ALL ‘ci’ =0.
 The test has a chi-squared distribution, and it has a single degree of
freedom.
 ONLY HOLDS IN LARGE SAMPLES.