Time Series: Basic Analysis

Karl Jandoc

School of Economics, University of the Philippines-Diliman

First Semester, AY 2016-2017

November 2, 2016
Time Series vs. Cross Section

Time series data has a temporal ordering

We need to change some of our assumptions since we need to
take into account that we no longer have a random sample of
individuals
Instead, we have one realisation of a stochastic (i.e. random)
process Stochastic - Sequence of random variables indexed by time
- Past can aect the future, but not vice versa

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Econ 131
Time Series Dataset

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Econ 131
 Example of Time Series Models
A change in z at time t is believed to have an immediate eect on y: yt = B1z1, when
ut=0 OR when knowing tradeo between z and y
Contemporaneous - Appearing at the same time
Modelling a contemporaneous relationship bet. 2 var

Static model: relates contemporaneous variables

mrdrte=B0+B1convrtet+b2unemt+B3yngmlet+ut
Ex: inft = B0+B1unemt+ut
Ceteris Paribus Eect of an increase in conviction rate on particular criminal activity
inft-annual inflation rate
unemt-unem rate
Assumes constant natural rate of unemployment and
t y = 0 +
1 t z +u t
constant inflationary expectations OR tradeo bet unemployment and inflation

Finite distributed lag (FDL) model: allows one or more

variables to aect y with a lag
Interpretation: Suppose that z is a constant (c) . At time t, z increases by 1 unit to c+1 and then reverts to its previous level at time t+1
(That is the increase in z is temporary)
More precisely, zt-2=c zt-1=c zt=c zt+1=c.etc
yt = 0 + 0 zt + 1 zt 1 + 2 zt 2 + ut
This is an FDL of order 2

In general, an FDL model of order q will include q lags of z

Ex: gfrt=0+0pet+1pet-1+xpet-2+ut Test whether z has a lagged eect on y
gfrt=general fertility rate
pe=personal tax exemption
See whether decision to have children is linked to tax value of having a child
Decision to have children would not immediately result from changes in personal exemption

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Econ 131
Finite Distributed Lag Models

Continuation from interpretation: yt - yt-1 = 0

therefore 0 is the immediate change in y due to one unit increase in z at time t

yt = 0 + 0 zt + 1 zt 1 + + q zt q + ut
Bec of substantial correlation in z at dierent lags, aka multicollinearity, it can be diicult to obtain precise estimates of the individual j

We call 0 the impact propensity: immediate change in y

if we have a permanent change in z, 0 + 1 + + q is the
long-run propensity Orperiods
the cumulative eect after all changes have taken place - change in the expected outcome h
after a permanent one unit increase in x
Change in y due to the permanent increase in z
We can add more than one explanatory variable appearing w/ lags or we can
After one period: 0+1
contemporaneous variables to an FDL model
2 periods: 0+1+2
Ex: Ave education level for women of childbearing age could be added
Occasionally omit zt in w/c case impact propensity is zero w/c allows us to account for changing education levels of women

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Econ 131
Unbiasedness

Still assume linearity in parameters:

yt = 0 + 1 xt1 + + betak xtk + ut
Still assume zero conditional mean: UtHolds
is uncorrelated with each explanatory variable in every time period
as long as u is independent of X and E(ut) = 0

E (ut |X) = 0, t = 1, 2, . . . , n
Error term in any given period is uncorrelated with the RHS
variables in all time periods
E.g., In the regression of GDP with interest rate, inflation rate
and budget deficit, unobservable factors in time t should not
be related with inflation, interest rate and budget deficit at
time . . . , t 2, t 1, t, t + 1, t + 2, . . .

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Econ 131
Unbiasedness
Example of last point: mrdtet=B0+B1polpct(policeforce)+ut
- Reasonable to assume that ut is uncorrelated with polpct and even with past and future values of polpct
- However, suppose city adjusts police force based on past values of murder rate
So, polpct+1 may be correlated with ut (since higher ut leaders to higher mrdrtet) therefore violated
Ex: Rainfall in any future year is not influenced by output in current or past years
But amount of labor input may not be strictly exogenous bec since it is chosen by farmers, farmer may adjust the amount of labor based on last years
yield
In economics, growth in money supply, expenditures on welfare,
ZCM: E (u |X) = 0, t = 1, 2, . . . , n
t
highway speed limits are often influenced by what has happened
to outcome variable in the past

if ZCM is satisfied implies the xs are strictly exogenous

Alternative assumption: E (ut |xt ) = 0 (xs are
E(ut|xta,xtk)=E(ut|xt)
contemporaneously exogenous) Corr(xtj,ut)=0 for all j, U and explanatory variables are contemporarily
uncorrelated

Contemporaneous exogeneity sufficient for consistency (in

large samples) uExplanatory
must be uncorrelated with xsj even when s=/t
variables must be exogenous and strictly exogenous when T3 holds.
Since random sampling is almost never appropriate, assume that expected value of ut is not related to explanatory variable in any time period
Assumption 3 fails when unobservables correlate with any explanatory variable
i.e. omitted variables and measurement error OR
Ex: Simple Static Regression: yt=B0+B1zt+ut
Requires not only that ut and zt uncorrelated but that ut is uncorrelated with past and future values of z
Implications: 1. z can have no lagged eect on y. If it does, estimate a distributed lag model
2. Strict exogeneity excludes the possibility that changes in error term today can cause future challenges in z. This rules out feedback from y to
future values of z

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Econ 131
Unbiasedness

Still need to assume no perfect collinearity Explanatory variables should not be correlated

We skipped random sampling!

Random sampling: each ui is independent
Strict exogeneity is sufficient

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Econ 131
Unbiasedness

If all these assumptions are satisfied, OLS estimators are

unbiased!
As with cross-section data, OLS estimators are unbiased even
with time-series data

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Econ 131
Variances of OLS Estimators
Var(ut|x) cannot depend on X
u and X must be independent and that Var(u) constant over time
heteroskedastic when it does not hold
Example: T-bill rates = B0+B1inf t+deficit t+ut
Requires that unobservables aecting interest rate have a constant variance
Since policy regime changes are known to aect variability of interest rates, assumption may be false
Also, it could be that variability in interest rates depends on level of inflation or size of deficit
WHEN VAR DEPENDS ON U, IT OFTEN DEPENDS ON THE EXPLANATORY VARIABLE AT TIME t, Xt.

Still assume homoskedasticity: Var (ut |X) = Var (ut ) = 2

Error variance is independent of all the xs and is constant

over time
New assumption: no serial correlation Corr (ut , us |X) = 0 for
t 6= s Not correlated across time
Example of Serial Correlation: Suppose u t-1 >0, then on average, the error in the next time period u t is also positive. Then
Corr(ut, ut-1)>0, error suers from serial correlation
This means that if interest rates are unexpectedly high for this period, they are likely to be above average for the next period
Nothing to do with temporal correlation - Ex: Inf is almost certainly correlated across time but does not violate TS 5
Potential problem since not random sampling like before

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Econ 131
Variances of OLS Estimators

Under these 5 assumptions, OLS variance in time-series are

the same as in the cross section
The estimator of 2 is the same
With extra assumption of normal distribution of errors,
inference is also the same!
Hence same interpretation of standard errors, t-values and
p-value
OLS is still the best linear unbiased estimator
Var(^Bj|X) = o^2/[SSTj(1-R^2)]
R example ^o^2=SSR/df

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Econ 131
Trending Time Series

Economic time series often have a trend

Just because 2 series are trending together, we cant assume a
causal relation (spurious regression)
Both may be trending because of unobserved factors
Even if those factors are unobserved, we can control for them
by controlling the trend directly!

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Econ 131
Trending Time Series

Linear trend: yt = 0 + 1 t + et , t = 1, 2, . . .
Exponential trend: yt = e 0 +1 t+et , t = 1, 2, . . .
Quadratic trend: yt = 0 + 1 t + 2 t 2 + et , t = 1, 2, . . .

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Econ 131
Trending Time Series

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Econ 131
Dummy variables

In time series, dummy variables represent whether a certain

event has occurred
E.g. Which year has a crisis erupted in the Philippines?
Event study: whether a particular event has an influence on
outcome

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Econ 131
Seasonality

Time series data may exhibit some periodicity

E.g. Electricity demand in Philippines is high during summer,
low on Christmas
Can be dealt with by adding seasonal dummies

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Econ 131