Congruency

Macroeconometrics
Congruency: Residual Properties, Parameter Constancy, Predictive Failure
Jaime Marquez
SAIS
Spring 2015
Jaime Marquez (SAIS)
Spring 2015
1 / 35
Anatomy of an equation
Pretend that economic theory shows that imports today depend on todays
income and nothing else
mt = 0 + 1 yt + ut =
yt
0
1
+ ut = xt + ut
m is the log of real imports

y is the log of real GDP
This equation assumes that

the residuals are normal, serially independent, and homoskedastic
all the 0 s are constant
there is not predictive "failure"
xt can be taken as given for parameter estimation (later in the course)
Parameter estimates rest on these assumptions

If we cannot reject these assumptions, then model is congruent
Congruency is a necessary, but not su cient, condition for useful inferences
Key reading is DH-I 18: Model Evaluation Statistics
Spring 2015
2 / 35
H:\Teaching\Spring 2015\Macroeconometrics\Engle-Granger-USimports.out 02/13/15 14:47:25

ImportsUS.in7 loaded from H:\Teaching\Spring 2015\Macroeconometrics\ImportsUS.in7
Algebra loaded from H:\Teaching\Spring 2015\Macroeconometrics\USImports.alg
Algebra code for ImportsUS.in7:
y = log(real_gdp);
m = log(real_imports);
PM = (nom_imports*100/real_imports)*(1+Tariff_Rate/100);
PY = nom_gdp *100 / real_gdp;
RPM =
PM / PY;
rpm = log(RPM);
Ypercapita = real_gdp/(population/10^9);
Mpercapita = real_imports / (population/10^9);
M_yshr = nom_imports *100 /nom_gdp;
ypcapita = log(Ypercapita);
mpcapita = log(Mpercapita);
Dy = diff(y,1);
Dm = diff(m,1);
Dypcapita = diff(ypcapita,1);
Dmpcapita = diff(mpcapita,1);
Drpm = diff(rpm,1);
Engle-Granger Cointegration
Ox Professional version 7.00 (Windows_64/U/MT) (C) J.A. Doornik, 19942013

PcGive 14.0B3 session started at
7:39:33 on 12022015
EQ( 1) Modelling m by OLS

The dataset is: H:\Teaching\Spring 2015\Macroeconometrics\ImportsUS.in7
The estimation sample is: 1929 2013
Constant
y
Coefficient
7.21714
1.52355
sigma
R^2
Adj.R^2
no. of observations
mean(m)
0.2884
0.956875
0.956355
85
5.57119
Std.Error
0.2996
0.03550
tvalue
24.1
42.9
m =
(SE)
F(2,81)
F(1,83)
Chi^2(2)
F(2,82)
F(2,82)
F(2,81)
=
=
=
=
=
=
P-value
345.95
246.74
26.120
86.436
86.436
461.84
[0.0000]**
[0.0000]**
[0.0000]**
[0.0000]**
[0.0000]**
[0.0000]**
Tests of Residuals' Properties
7.2 + 1.5*y
(0.3) (0.036)
Solved static longrun equation for m

Coefficient Std.Error
Constant
7.21714
0.2996
y
1.52355
0.03550
Longrun sigma = 0.2884
tvalue
24.1
42.9
ECM = m + 7.21714 1.52355*y;

WALD test: Chi^2(1) = 1841.62 [0.0000] **
residuals [1929 2013] saved to ImportsUS.in7
Page: 1 of 2
Assumed long-run relation
RSS
6.90347459
F(1,83) =
1842 [0.000]**
loglikelihood
13.9082
no. of parameters
2
se(m)
1.38047
Instability tests:
variance
2.7717**
joint
8.0510**
Individual instability tests:
Constant
1.7011**
y
2.0427**
AR 12 test:
ARCH 11 test:
Normality test:
Hetero test:
HeteroX test:
RESET23 test:
tprob Part.R^2
0.0000
0.8748
0.0000
0.9569
tprob
0.0000
0.0000
H:\Teaching\Spring 2015\Macroeconometrics\Engle-Granger-USimports.out 02/13/15 14:47:25
Descriptive Statistics 1.01 session started at
7:45:23 on 12022015
Testing whether residuals are stationary

Unitroot tests
The sample is: 1940 2013 (85 observations and 1 variables)
residuals: ADF tests (T=74, Constant+Trend; 5%=3.47 1%=4.09)
Dlag
tadf
beta Y_1
sigma
tDY_lag tprob
AIC
10
4.265**
0.79937 0.05352
1.208 0.2316
5.697
9
4.228**
0.80040 0.05372
0.5952 0.5539
5.701
8
4.244**
0.80068 0.05344
0.6302 0.5308
5.722
7
4.259**
0.80092 0.05319
1.717 0.0909
5.743
6
4.171**
0.80215 0.05398
0.1266 0.8997
5.725
5
4.203**
0.80217 0.05357
0.4310 0.6678
5.752
4
4.238**
0.80175 0.05325
0.5224 0.6031
5.776
3
4.406**
0.79775 0.05296
1.117 0.2681
5.799
2
4.383**
0.79845 0.05306
1.571 0.1208
5.808
1
4.808**
0.78228 0.05361
0.1420 0.8875
5.800
0
4.852**
0.78292 0.05324
5.826
Page: 2 of 2
Fprob
0.2316
0.4085
0.5337
0.2874
0.4093
0.5096
0.5909
0.5613
0.4294
0.5158
Properties of the Residuals
For relevant statistical inference, the residuals need to satisfy

Serially independence
Homoskedasticity
Normality
Spring 2015
4 / 35
Properties of the Residuals: Serial Independence
The term ut is serially independent if

E (ut ut s ) = 0 for all s
The test for serial independence uses the following regression:
u
bt = 1 u
bt 1 + 2 u
bt 2 +
and test the null hypothesis that
1 = 2 =
+ n ubt
= n = 0
If we cannot reject this hypothesis, then residuals areserially independent

PcGive automatically prints this test under the heading of AR(n)
Spring 2015
5 / 35
Fitted
The estimation sample is: 1929 - 2013
m = - 7.2 + 1.5*y
(SE) (0.3) (0.036)
6
5
4
3
1930
2
1940
1950
1960
1970
1980
1990
2000
2010
2000
2010
r:m (scaled)
AR 1-2 test:
F(2,81) = 345.95 [0.0000]**
-1
1930
1940
1950
1960
1970
1980
1990
Spring 2015
6 / 35
Properties of the Residuals: Homoskedasticity

The term ut is homoskedastic if
E (ut2 ) = 2u
There are several tests of homoskedasticity
Focus here is on the Autoregressive Conditional Heteroskedasticity ARCH:
2ut = 0 + 1 2u,t 1 +
+ n 2t
The equation says that the variance today depends on the variance in the past
Glitch: we do not have data on 2ut
Then the test uses
u
bt2 = 0 + 1 u
bt2 1 +
and test the null hypothesis that
1 = 2 =
+ n ubt2
= n = 0
If we cannot reject this hypothesis, then the residuals arehomoskedastic

PcGive automatically prints this test under the heading of ARCH(n )
Spring 2015
7 / 35
0.40
residsqrd
0.35
m = - 7.2 + 1.5*y
(SE) (0.3) (0.036)
0.30
0.25
residsqrd = + 0.82*residsqrd_1 + 0.012

(SE)
(0.052)
(0.0062)
0.20
ARCH 1-1 test:
F(1,83) = 246.74 [0.0000]**
0.15
0.10
0.05
1930
1940
1950
1960
1970
1980
1990
2000
2010
Spring 2015
8 / 35
Properties of the Residuals: Normality
The disturbance ut is treated as normally distributed if the empirical

distribution of u
bt satises two properties of the normal distribution: there is
no skewness and no excess kurtosis
The normal distribution has a skewness of zero. So if the distribution of u
bt
has skewness, then it is not symmetric and therefore it is not normal
Kurtosis is the degree of concentration of observations around the mean. The

kurtosis of the normal distribution is 3. So we test the "excess" kurtosis
It turns out (DH-I 18.5.4) that the skewness and the excess kurtosis are two
independent 2 (1) so their sum is 2 (2)
PcGive automatically prints this test under the heading of NORMAL
Spring 2015
9 / 35
Density
residuals
m = - 7.2 + 1.5*y
(SE) (0.3) (0.036)
2.00
Normality test: Chi^2(2) = 26.120 [0.0000]**
1.75
1.50
1.25
1.00
0.75
0.50
0.25
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
Spring 2015
10 / 35
Parameter Constancy
Given
mt = 0 + 1 yt + ut =
yt
0
1
+ ut = xt + ut
Do parameter estimates change when the estimation sample dates change?

estimate with an initial sample
add one observation and re-estimate
continue until the full sample is used for parameter estimation
Subsample
Dates
Estimate
Std. Error
1929-1939
1929-1940
1929-2013
1
2
75
b
1
b
2
b
stder(b
1 )
stder(b
2 )
b
stder( 75 )
75
0
Plot evolution of the 95% condence band of the b
i s for each subsample:
b
i
2 stder (b
i ), i = 1, 2, ..., 75
Spring 2015
11 / 35
2.5
Constant
+/-2SE
0.0
Estimates based on all the data

m = - 7.2 + 1.5*y
(SE) (0.3) (0.036)
-2.5
-5.0
-7.5
1940
1950
1960
1970
1980
1990
2000
2010
y +/-2SE
1.5
1.0
95% confidence band for slope
using data throug 1980
0.5
1940
1950
1960
1970
1980
1990
2000
2010
Spring 2015
12 / 35
Forecasting: General Considerations
Forecasting is an important application of Macroeconometrics

Policy institutions generate forecasts for macroeconomic aggregates
The IMFs World Economic Outlook
The Federal Open Market Committee
The Congressional Budget O ce
Private business also forecast frequently
Spring 2015
13 / 35
Figure 1. Central tendencies and ranges of economic projections, 201417 and over the longer run
Percent
Change in real GDP

Central tendency of projections
Range of projections
Actual
+
0
-
2009
2010
2011
2012
2013
2014
2015
2016
2017
Longer
run
Percent
Unemployment rate
10
9
8
7
6
5
2009
2010
2011
2012
2013
2014
2015
2016
2017
Longer
run
Percent
PCE inflation
2009
2010
2011
2012
2013
2014
2015
2016
2017
Longer
run
Note: Definitions of variables are in the general note to the projections table. The data for the actual values of
the variables are annual.
Predictive Failure DH-I 15.7

Predictive failure refers to the models inability to predict the data outside
the estimation sample
Suppose we use
mt = 0 + 1 yt + ut =
yt
0
1
+ ut = xt + ut
Estimate the parameters from 1929 to 1963 and predict y for all dates 1963
m
b t = xt b
, t = 1964...2013
We want accurate predictions
But we know that we get forecast errors

We want to know whether the error we get is "too" large
Large relative to the range of values one can reasonably expect
So we need the expectation and variance of the forecast error
Spring 2015
15 / 35
Forecast Error
The forecast error is
et = mt
m
b t = [ xt + u t ]
What are the sources of forecast error?

1
xt + u t
Parameters need to be estimated

Estimation is not guaranteed to deliver the true values
Model uncertainty: The value of disturbance u is unknown

1
2
i h
xt b
=
Parameter uncertainty: We do not know the true values of the parameters

1
change of policies at home or abroad

weather developments
The explanatory variable is measured with error

1
2
data revisions for the current quarter

vintages
Spring 2015
16 / 35
Derivation of Condence Bands
Goal: condence interval for the forecast error to see if it is toolarge

0
The forecast error is random because it depends on b
s and u 0 s - we ignore
measurement error in x
If we had the variance of the forecast error, F t , then the rule is
The forecast error is within the bounds of condence if
2Ft < mt
m
b t < +2Ft
or the forecast error is outside the bounds of condence if

mt
mt
m
bt
m
bt
<
>
2Ft
+2Ft
So what we need now is to construct a measure of F t
Spring 2015
17 / 35
The expectation of mt
E (mt
m
b t is
6
7
m
b t ) = 4 xt + E ( u t ) 5
| {z }
=0
If E (b
) = , then
The variance of mt
var (mt
E (mt
m
b t is
m
bt)
m
b t ) = [ xt ]
= E [(mt
m
b t )]
xt E (b
)
[ xt ] = 0
= 2F = E [(mt
= E [(mt
m
bt)
E (mt m
b t ) ]2
{z
}
|
E (mt )) + (E (mt )
m
b t )]2
Spring 2015
18 / 35
After a fair amount algebraic gymnastics, we get

2F
= E [mt
= 2 + 2y
2 = E [yt
E (m
b t )]2 + E [E (m
bt)
m
b t )]2
E (yt )]2 : Model uncertainty due to the disturbance u
2y = E [E (yt ) ybt )]2 : Parameter uncertainty due to using parameter

estimates instead of true values
PcGive gives you the option of using 2 or both 2 and 2y
Spring 2015
19 / 35
Condence Bands
Once we get the variance of the forecast error, F t , then the rule we follow is
The forecast is within the bounds of condence if
2F t < mt
which can re-written as
m
bt
m
b t < +2F t
2F t < mt < m
b t + 2F t
The forecast is outside the bounds of condence if

mt
mt
< m
b t 2F t
> m
b t + 2F t
Spring 2015
20 / 35
Types of Forecasts
Ex-post: data for forecast drivers are known from history

Ex-ante: data for forecast drivers are not known; forecaster has to provide
values for the forecast drivers
1-period ahead: values for the drivers come from historical data including
values for lags of the dependent variable
s-period ahead: the model uses its own predictions for lags of the dependent
variable
Spring 2015
21 / 35
Ex-post forecasts
Model
yt = + xt + yt 1 + u t
We have data for yt and xt for t = 1, ..., T from history
We want to assess how good the model predicts outside the estimation
sample
Estimate the parameters using N < T observations.
Generate forecasts from h = N + 1 to T
Set the disturbance to zero
Spring 2015
22 / 35
Ex-post forecasts: 1-period ahead

Predictions use historical data including values for lags of the dependent
variable
The forecast for h = 1 is
b yN , h = 1...T
ybN +1 = b
+b
xN + 1 +
b yN + 1
ybN +2 = b
+b
xN + 2 +
The forecast for t = T
N is
b yT 1
ybT = b
+b
xT +
In general, the ex-post 1-step forecast is expressed as

b yN +h 1 ; h = 1...T
ybN +h = b
+b
xN + h +
Values for lags of y are reset to history

Previous forecast errors do not matter
Spring 2015
23 / 35
The 1-period ahead forecast error is

eN +h = yN +h
What are the sources of the forecast error?
eN +h
= [ + xN +h + yN +h
|
{z
y N +h
= [
|
b
] +
ybN +h
+ uN + h ]
}
h
b
xN +h +
{z
parameter uncertainty
i
b N +h 1
b
+b
xN +h + y
{z
}
|
b yN +h 1 +
ybN +h
uN + h
| {z }
model uncertainty
Spring 2015
24 / 35
Illustration with the price of oil

Assume that the price of oil is explained by its own history and nothing else:
yt
= + ( L ) yt
12
(L)
+ ut
Lj
j =0
The long-run value of y is 1
(1 )
Estimate parameters with data from January 1987 to December 2013

Generate 1-period ahead forecasts from January 2014 to December 2014
In this application, a forecast for February 2014 does not feed into the
forecast for March of 2014 because the model uses historical values for lags
Spring 2015
25 / 35
1-step Forecasts
West_Texas_Nominal
110
100
90
80
Model
Dependent variable: level of nominal West Texas oil price
Explanatory variables: constant + 12 lags of the dependent variable
70
60
2013
2014
2015
Spring 2015
26 / 35
Ex-post forecasts: s-periods ahead

The model uses its own predictions for lags of the dependent variable
b yN
ybN +1 = b
+b
xN + 1 +
where yN is known because we have data for it

b ybN +1
ybN +2 = b
+b
xN + 2 +
where we are using ybN +1 instead of the observed value yN +1

The forecast for t = T N is
b ybT 1
ybT = b
+b
xT +
In general, the ex-post s-period ahead forecast is
for h = 1, 2,
(T
b ybN +h 1
ybN +h = b
+b
xN + h +
N)
Spring 2015
27 / 35
The s-periods ahead forecast error is

eN +h
= yN +h
ybN +h
= [ + xN +h + yN +h
= [
h
b
] +
+ uN + h ]
xN + h + yN + h 1
b yN + h 1
b
+b
xN +h + b
b yN +h 1 + uN +h
b
b then
If we knew the true values of the parameters - = b
; = b
; =
eN + h
= (yN +h 1 ybN +h
= eN +h 1 + uN +h
1 ) + uN + h
There is no resetting of lagged values of the dependent variable to history

Forecast errors accumulate
Spring 2015
28 / 35
Same model for oil prices but now I use the models own predictions for
lagged values of the endogenous variable:
130
Foreca sts
W est_T e xas_Nom inal
120
110
100
90
80
70
60
2013
Model
Dependent variable: level of nominal West Texas oil price
Explanatory variables: constant + 12 lags of the dependent variable
2014
2015
Note that the blue line is converging to the long-run value of y is 1

(1 )
Spring 2015
29 / 35
Application to U.S. Imports
Goal estimation of the income elasticity for U.S. imports

The model is
mt = 0 + 1 yt + 2 mt 1 + ut
m is the log of real imports) dm= percent change of m
y is the log of real GDP ) dy = percent change of y
) dm
dy = 1 is the income elasticity
Estimate parameters using data from 1929 to 1963 and generate 1-period
and s-periods ahead ex-post forecasts
Spring 2015
30 / 35
H:\Teaching\Spring 2015\Macroeconometrics\Koyck-Lag-US-imports.out 02/13/15 14:50:52
EQ( 8) Modelling m by OLS

The estimation sample is: 1930 1963
m_1
Constant
y
Coefficient
0.650539
1.06253
0.338683
sigma
R^2
Adj.R^2
no. of observations
mean(m)
0.100236
0.948394
0.945065
34
4.17776
Std.Error
0.1009
0.3226
0.08631
tvalue
6.45
3.29
3.92
tprob Part.R^2
0.0000
0.5728
0.0025
0.2592
0.0005
0.3319
RSS
0.311465034
F(2,31) =
284.9 [0.000]**
loglikelihood
31.5342
no. of parameters
3
se(m)
0.42766
Instability tests:
variance
0.34130
joint
1.4947*
Individual instability tests:
m_1
0.22652
Constant
0.18493
y
0.20693
1step (ex post) forecast analysis 1964 2013
Parameter constancy forecast tests:
Forecast Chi^2(50) =
671.86 [0.0000]**
Chow
F(50,31) = 0.50003 [0.9859]
CUSUM
t(49)
=
2.370 [0.0218]* (zero forecast innovation mean)
AR 12 test:
ARCH 11 test:
Normality test:
Hetero test:
HeteroX test:
RESET23 test:
m =
(SE)
F(2,29)
F(1,32)
Chi^2(2)
F(4,29)
F(5,28)
F(2,29)
=
2.7391 [0.0814]
= 0.049469 [0.8254]
=
3.5178 [0.1722]
=
1.4738 [0.2358]
=
1.4805 [0.2277]
=
7.1677 [0.0030]**
Residuals are OK
+ 0.65*m_1 1.1 + 0.34*y

(0.1)
(0.32) (0.086)
Solved static longrun equation for m

Constant
3.04047
0.8834
y
0.969160
0.1190
Longrun sigma = 0.28683
tvalue
3.44
8.14
tprob
0.0016
0.0000
long-run income elasticity
Page: 1 of 1
Persistence
short-run income elasticity
Parameter constancy
Persistence: Lagged dep. variable
m_1
+/-2SE
0.5
0.0
1940
2.5
1945
Constant
1950
1955
1960
1965
1950
1955
1960
1965
1950
1955
1960
1965
+/-2SE
0.0
-2.5
1940
1945
y +/-2SE
1.0
Income
0.5
1940
1945
Spring 2015
32 / 35
Distribution of lagged eects
0.3
0.2
0.1
10
15
20
25
30
35
40
10
15
20
25
30
35
40
1.0
y(cum)
0.8
0.6
0.4
0
Spring 2015
33 / 35
Ex-post 1-period ahead forecasts

1-step Forecasts
m_1
0.650539 0.1009
Constant
-1.06253 0.3226
y
0.338683 0.08631
7.5
7.0
6.5
6.0
5.5
AR 1-2 test: F(2,29) = 2.7391 [0.0814]

ARCH 1-1 test: F(1,32) = 0.049469 [0.8254]
Normality test: Chi^2(2) = 3.5178 [0.1722]
5.0
4.5
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Spring 2015
34 / 35
Ex-post s-period ahead forecasts
Forecasts
7.5
m_1
Constant
y
7.0
0.650539
0.1009
-1.06253
0.3226
0.338683 0.08631
6.5
6.0
5.5
5.0
AR 1-2 test:
F(2,29) = 2.7391 [0.0814]
ARCH 1-1 test: F(1,32) = 0.049469 [0.8254]
Normality test: Chi^2(2) = 3.5178 [0.1722]
4.5
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Spring 2015
35 / 35

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Macroeconometrics

Congruency: Residual Properties, Parameter Constancy, Predictive Failure

Jaime Marquez (SAIS)

m is the log of real imports

This equation assumes that

Parameter estimates rest on these assumptions

H:\Teaching\Spring 2015\Macroeconometrics\Engle-Granger-USimports.out 02/13/15 14:47:25

Ox Professional version 7.00 (Windows_64/U/MT) (C) J.A. Doornik, 19942013

EQ( 1) Modelling m by OLS

Tests of Residuals' Properties

Solved static longrun equation for m

ECM = m + 7.21714 1.52355*y;

Assumed long-run relation

H:\Teaching\Spring 2015\Macroeconometrics\Engle-Granger-USimports.out 02/13/15 14:47:25

Descriptive Statistics 1.01 session started at

Testing whether residuals are stationary

Properties of the Residuals

For relevant statistical inference, the residuals need to satisfy

Jaime Marquez (SAIS)

Properties of the Residuals: Serial Independence

The term ut is serially independent if

and test the null hypothesis that

If we cannot reject this hypothesis, then residuals areserially independent

Jaime Marquez (SAIS)

The estimation sample is: 1929 - 2013

F(2,81) = 345.95 [0.0000]**

Jaime Marquez (SAIS)

Properties of the Residuals: Homoskedasticity

and test the null hypothesis that

If we cannot reject this hypothesis, then the residuals arehomoskedastic

The estimation sample is: 1929 - 2013

residsqrd = + 0.82*residsqrd_1 + 0.012

ARCH 1-1 test:

F(1,83) = 246.74 [0.0000]**

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Properties of the Residuals: Normality

The disturbance ut is treated as normally distributed if the empirical

Kurtosis is the degree of concentration of observations around the mean. The

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The estimation sample is: 1929 - 2013

Normality test: Chi^2(2) = 26.120 [0.0000]**

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Do parameter estimates change when the estimation sample dates change?

Estimates based on all the data

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Forecasting: General Considerations

Forecasting is an important application of Macroeconometrics

Private business also forecast frequently

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Change in real GDP

Predictive Failure DH-I 15.7

We want accurate predictions

But we know that we get forecast errors

What are the sources of forecast error?

Parameters need to be estimated

Model uncertainty: The value of disturbance u is unknown

Parameter uncertainty: We do not know the true values of the parameters

change of policies at home or abroad

The explanatory variable is measured with error

data revisions for the current quarter

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Derivation of Condence Bands

Goal: condence interval for the forecast error to see if it is toolarge

+ 0.65m_1 1.1 + 0.34y