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Introductory Econometrics with EViews

Asst. Prof. Dr. Kemal Bağzıbağlı

Department of Economic

Res. Asst. Pejman Bahramian

PhD Candidate, Department of Economic

Res. Asst. Gizem Uzuner

MSc Student, Department of Economic

EViews Workshop Series Agenda

1. Introductory Econometrics with EViews

2. Advanced Time Series Econometrics with EViews

a. Unit root test and cointegration

b. Vector Autoregressive (VAR) models

c. Structural Vector Autoregressive (SVAR) models

d. Vector Error Correction Models(VECM)

e. Autoregressive Distributed Lag processes

3. Forecasting, and Volatility Models with EViews

a. Forecasting

b. Volatility models

c. Regime Switching Models

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Part 1 - Outline

1. Violation of Classical Linear Multiple Regression (CLMR) Assumptions

a. Heteroskedasticity

b. Multicollinearity

2. “Stationarity is Job 1!”

c. Model Misspecification

d. Autocorrelation

3. Univariate Time Series Modelling

a. Autoregressive Integrated Moving Average (ARIMA) model

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1. Violation of Classical

Linear Multiple Regression (CLMR)

Assumptions

Multiple Regression Model

Deterministic components

n observations on y and x:

α & β i : unknown parameters

Stochastic component

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Assumptions

1) The error term (u t ) is a random variable with E(u t )=0. 2) Common (constant) Variance. Var(u t ) = σ 2 for all i. 3) Independence of u t and u j for all t. 4) Independence of x j

u t and x j are independent for all t and j.

5) Normality

u t are normally distributed for all t.

● In conjunction with assumptions 1, 2 and 3;

u t IN (0, σ 2 )

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Violation of Basic Model Assumptions

HETEROSKEDASTICITY (nonconstant variance)

var(u t ) = E(u t 2 ) = σ 2 for all t (similar distribution) Homoskedasticity:

n

● σ 1 2 = σ 2 2 = … = σ 2

● Constant dispersion of the error terms around their mean zero

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Heteroskedasticity (cont.)

Rapidly increasing or decreasing dispersion heteroskedasticity? Variances are different because of changing dispersion

σ 1 2 ≠ σ 2 2

2

σ 2 n

Var(u t )=

σ t One of the assumptions is violated!

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Heteroskedasticity (cont.)

Residuals increasing by x heteroskedasticity?

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Consequences of Heteroskedasticity

The ordinary least squares (OLS) estimators are still unbiased but inefficient.

Inefficiency: It is possible to find an alternative unbiased linear estimator that has a lower variance than the OLS estimator.

Consequences of Heteroskedasticity (cont.) Effect on the Tests of Hypotheses

The estimated variances and covariances of the OLS estimators are biased and inconsistent

invalidating the tests of hypotheses (significance)

Effect on Forecasting

Forecasts based on the estimators will be unbiased

Estimators are inefficient

forecasts will also be inefficient

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Lagrange Multiplier (LM) Tests for Heteroskedasticity

1. Park Test is a two-stage procedure

Stage 1:

● Run an OLS regression disregarding the heteroskedasticity question.

● Obtain u t from this regression;

Stage 2:

● if β is statistically significant, there is heteroskedasticity.

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Park Test in EViews

ls compensation c productivity

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Park Test in EViews (cont.)

Park Test in EViews (cont.)

u=0

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Park Test in EViews (cont.)

u2=u^2

Park Test in EViews (cont.)

lnu2=log(u2)

lnproductivity=log(productivity)

Park Test in EViews (cont.)

Probability value (p-value) of lnproductivity (0.5257) is greater than the critical value of 0.05 Statistically insignificant homoskedasticity

Detection of Heteroskedasticity (cont.)

 2. Glejser Test is similar in spirit to the Park test. ● Glejser (1969) suggested estimating regressions of the type; Iû t I = α + βX t Iû t I = α + β/X t Iû t I = α + β√X t and so on ● Testing the hypothesis β=0

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Glejser Test in EViews

genr au=@abs(u)

Glejser Test in EViews (cont.)

ls au c productivity

Heteroskedasticity?

Glejser Test in EViews (cont.)

ls au c 1/productivity

ls au c @sqrtproductivity

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Glejser Test in EViews (cont.)

ls compensation c productivity

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Glejser Test in EViews (cont.)

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Detection of Heteroskedasticity (cont.)

3. White’s Test

● Recommended over all the previous tests

Step 1: Obtain

Step 2: Compute the residual and square it

by OLS

Detection of Heteroskedasticity (cont.)

3. White’s Test (cont.) Step 3: Regress the squared residual against a constant, X 2t , X 3t etc. (auxiliary equation)

Step 4: Compute the statistic nR 2

● n: sample size, R 2 : unadjusted R 2 from S.3

Detection of Heteroskedasticity (cont.)

3. White’s Test (cont.) Step 5: Reject the null hypothesis that

● if

○ Upper a percent point on the chi-square dist. with 5 d.f.

● If the null hypothesis is not rejected

○ the residuals are homoskedastic

White Test in EViews

Solutions to the Heteroskedasticity Problem

Taking the logarithm of Y t and X t

variance becomes smaller.

Use the weighted least squares (WLS)

Better than the first solution

Guaranties homoskedasticity.

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Solutions to the Heteroskedasticity Problem (cont.)

Graphical Method

● Check the residuals (i.e. error variance)

linearly increasing with x t

● WLS

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Solutions to the Heteroskedasticity Problem (cont.)

● Not linearly but quadratically increasing error variance

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Solutions to the Heteroskedasticity Problem (cont.)

● Error variance decreasing
linearly

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Applications with EViews

ls foodexp c totalexp

foodexp c totalexp

01.makeresid u

Applications with EViews (cont.)

Command:

scat totalexp u

heteroskedasticity?

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Applications with EViews (cont.)

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Applications with EViews (cont.)

lnfoodexp=log(foodexp)

lntotalexp=log(totalexp)

Applications with EViews (cont.)

Command:

ls lnfoodexp c lntotalexp

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Applications with EViews (cont.)

Multicollinearity

OLS

Ordinary Least Squares

BLUE classical normal linear

Independent variables in the regression model are not correlated.

What is Multicollinearity?

● The problem of multicollinearity arises when the explanatory variables have approximate linear relationships.

○ i.e. explanatory variables move closely together

● In this situation, it would be difficult to isolate the partial effect of a single variable. WHY?

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Multicollinearity (cont.)

1. Exact (or Perfect) Multicollinearity

a. Linear relationship among the independent variables

2. Near Multicollinearity

a. Explanatory variables are approximately linearly related

For example; If

Exact

Near

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Theoretical Consequences of Multicollinearity

Unbiasedness & Forecasts

OLS estimators are still BLUE and MLE and hence are unbiased, efficient and consistent.

Forecasts are still unbiased and confidence intervals are valid

Although the standard errors and t-statistics of regression coefficients are numerically affected,

○ tests based on them are still valid

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Theoretical Consequences of Multicollinearity (cont.)

Standard Errors

Standard errors tend to be higher

○ making t-statistics lower

○ thus making coefficients less significant (and possibly even insignificant)

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Identifying Multicollinearity

● High R 2 with low values for t-statistics
● High values for correlation coefficients
● Regression coefficients sensitive to specification Formal test for multicollinearity

CI=√k

Eigenvalues and condition index (CI)

k= max eigenvalues/min eigenvalues

k is between 100 and 1000 multicollinearity?

High variance inflation factor (VIF)

VIF>10 THEN multicollinearity is suspected.

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Solutions to the Multicollinearity Problem

● Benign Neglect

○ Less interested in interpreting individual coefficients but more interested in forecasting

● Eliminating Variables

○ The surest way to eliminate or reduce the effects of multicollinearity

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Solutions to the Multicol. Problem (cont.)

● Reformulating the Model

○ In many situations, respecifying the model can reduce multicollinearity

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Solutions to the Multicol. Problem (cont.)

● Using Extraneous Information

○ Often used in the estimation of demand functions

○ High correlation between time series data on real income and the price level

■ Making the estimation of income and price elasticities difficult

○ Estimate the income elasticity from cross-section studies

and then use that information in the time series model to estimate the price elasticity

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Solutions to the Multicol. Problem (cont.)

● Increasing the Sample Size

○ reduces the adverse effects of multicollinearity

R 2 , including the new sample

■ goes down or remains approx. the same

● the variances of the coefficients will indeed decrease and counteract the effects of multicollinearity

■ goes up substantially

there may be no benefit to adding to the sample size

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Applications with EViews

Overall statistically significant

but one by one statistically insignificant

multicollinearity

problem

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Applications with EViews (cont.)

Command: eq01.varinf

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Applications with EViews (cont.)

Command: scalar ci= @sqrt(66795998/3.44E-06)

CI: Condition Index

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Applications with EViews (cont.)

The highest correlation is between the price of cars and the general price level.

Even if we drop these variables one-by-one from the model, still we have a multicollinearity problem.

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Applications with EViews (cont.)

● When we drop both the general price level and the price of cars, the multicollinearity problem is solved

○ but R 2 is low.

● So we check the second highest correlation between disposable income and price level.

Applications with EViews (cont.)

DROP: General price level and disposable income

After removing the variables, the problem is solved.

Loss of valuable information?

It is better to try solving the problem by increasing the sample size

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Model Misspecification

1. Omitting Influential or Including Non- Influential Explanatory Variables

2. Various Functional Forms

3. Measurement Errors

4. Tests for Misspecification

5. Approaches in Choosing an Appropriate Model

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The Ramsey RESET Test

RESET: Regression specification error test

Step 1: Estimate the model that you think is correct and obtain the fitted values of Y, call them

Step 2: Estimate the model in Step 1 again, this

time include variables.

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The Ramsey RESET Test (cont.)

Step 3: The model in Step 1 is the restricted model and the model in Step 2 is the unrestricted model.

Calculate the F-statistic for these two models.

● i.e. carry out a Wald F-test for the omission of the two new variables in Step 2

● If the null hypothesis (H 0 : the new variables have no effect)

is rejected

indication of a specification error

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Autocorrelation

In the presence of autocorrelation, cov( u t ,u s )≠0 for t≠s and the error for period t is correlated with the error for period s.

-1< ρ <1

○ ρ approaching 0

○ ρ approaching +1

○ ρ approaching -1

no correlation positive correlation negative correlation

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Autocorrelation (cont.)

Causes of Autocorrelation

 DIRECT INDIRECT ● Inertia or Persistence ● Omitted Variables ● Spatial Correlation ● Functional Form ● Cyclical Influences ● Seasonality

Consequences of Autocorrelation

● OLS estimates are still unbiased and consistent

● OLS estimates are inefficient

not BLUE

○ Forecasts will also be inefficient

● The same as the case of ignoring heteroskedasticity

● Usual formulas give incorrect standard errors for OLS estimates

● Confidence intervals and hypothesis tests based on the usual standard errors are not valid

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Detecting Autocorrelation

Runs Test: Investigate the signs of the residuals. Are they moving randomly? (+) and (-) comes randomly don’t need to suspect autocorrelation problem.

Durbin-Watson (DW) d Test: Ratio of the sum of squared differences in successive residuals to the residual sum of squares.

Breusch-Godfrey LM Test: A more general test which does not assume the disturbance to be AR(1).

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Durbin-Watson d Test

STEP 1 Estimate the model by OLS and compute the residuals u t

STEP 2 Compute the Durbin-Watson d statistic:

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Durbin-Watson d Test (cont.)

STEP 3 Construct the table with the calculated DW
statistic and the d U , d L , 4-d U and 4-d L critical values.
STEP 4 Conclude

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Resolving Autocorrelation

The Cochrane-Orcutt Iterative Procedure

Step 1: Estimate the regression and obtain residuals.

Step 2: Estimate the first-order serial correlation coefficient () from regressing the residuals to its lagged terms.

Step 3: Transform the original variables as follows:

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Resolving Autocorrelation (cont.)

Step 4: Run the regression again with the transformed variables and obtain a new set of residuals. Step 5 and on: Continue repeating Steps 2 to 4 for several rounds until the following stopping rule applies:

● the estimates of from two successive iterations differ by no more than some preselected small value, such as 0.001.

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Applications with EViews

Variables in natural logarith:

● LNCO: Copper price

● LNIN: Inudtrial production

● LNLON: London stock exchange

● LNHS: Housing price

● LNAL: Aluminium price

1.143
1.739
AUTOCORRELATION?

Applications with EViews (cont.)

H 0 : No autocorrelation

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Applications with EViews (cont.)

To Fix it!

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Applications with EViews (cont.)

To Fix it!

u=u(0)

Applications with EViews (cont.)

To Fix it!

Generate series:

● y= lnco-0.52*lnco(-1)

● x 2 = lnin-0.52*lnin(-1)

● x 3 = lnlon-0.52*lnlon(-1)

● x 4 = lnhs-0.52*lnhs(-1)

● x 5 = lnal-0.52*lnal(-1)

Applications with EViews (cont.)

To Fix it!

1.124

1.743

Command:

ls y c x2 x3 x4 x5

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Applications with EViews (cont.)

To Fix it!

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Summary

 Problem Source Detection Remedy Heteroskedasticity Nonconstant variance Park Test, Glejser, White Test Taking logarithm, Weighted least squares Autocorrelation E(u t ,u t-1 )≠0 Durbin-Watson d Test, Run Test, Breusch Godfrey LM Test Cochrane-Orcutt Iterative Procedure and GLS Multicollinearity Interdependence of x j ● High R 2 but few significant t ratios ● Reformulating the model ● High pairwise correlation between independent variables ● Dropping variables, ● Additional new data ● Faitor analysis ● Eigenvalues and condition index, High VIF, Auxiliary Regressions ● Principal comp. analysis

2. “Stationarity is Job 1!”

What is Stationarity?

● A stationary series can be defined as one with a

constant mean, constant variance and constant autocovariances

for each given lag.

● The mean and/or variance of nonstationary series are time dependent.

● The correlation between a series and its lagged values depend only on the length of the lag and not on when the series started.

● A series that is integrated of order zero, i.e. I(0).

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noise
series
of a

Example of a

white

process

Time

plot

random walk vs. a random walk with drift

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Example

PDI: Personal Disposable Income

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What is Stationarity? (cont.)

● If a regression model is not stationary,

the usual “t-ratios” will not follow a t-distribution.

The use of nonstationary data can lead to spurious regressions.

● Results of the regression do not reflect the real relationship except if these variables are cointegrated.

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3. Univariate Time Series Modelling

Some Stochastic Processes

Random Walk

Moving Average Process

Autoregressive Process

Autoregressive Moving Average Process

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Autoregressive Integrated MA Process

Most time series are nonstationary

Successive differencing

stationarity

: A stationary series that can be expressed by an ARMA(p, q)

can be represented by an ARIMA model ARIMA(p, d, q)

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Estimation and Forecasting with an ARIMA Model

The Box and Jenkins (1970) Approach

● Identification

● Fitting (Estimation), usually OLS

● Diagnostics

● Refitting if necessary

● Forecasting

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Identification

● The process of specifying the orders of differencing, AR modeling, and MA modeling

● How do the data look like?

● What pattern do the data show?

- Are the data stationary?

- Specification of p, d, and q?

● Tools

- Plots of data

- Autocorrelation Function (ACF)

- Partial ACF (PACF)

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Identification (cont.)

● To determine the value of p and q we use the graphical properties of the autocorrelation function and the partial autocorrelation function.

● Again recall the following:

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Model Fitting

● Model parameters are estimated by OLS

● Output includes

Parameter estimates

Test statistics

Goodness of fit measures

Residuals

Diagnostics

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Diagnostics

● Determines whether the model fits the data adequately.

○ The aim is to extract all information and ensure that residuals are white noise

● Key measures

○ ACF of residuals

○ PACF of residuals

○ Ljung-Box Pierce Q statistic

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Preliminary Analysis with EViews

Select the series “dividends” in the workfile, then select [Quick/Graph/Line graph]:

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Preliminary Analysis with EViews (cont.)

[Quick/Generate Series]:

ddividends=d(dividends)

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Preliminary Analysis: Identification
Correlogram
The graph of autocorrelation function
against s, for s = 0, 1, 2, …, t-1
● Useful diagram for identifying patterns
in correlation among series.
● Useful guide for determining how
correlated the error term (u t ) is to the
past errors u t-1 , u t-2 ,
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Preliminary Analysis: Identification

Interpretation of Correlogram

● If is high, correlogram for AR (1) declines slowly over time

○ First differencing is indicated

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Preliminary Analysis: Identification
Interpretation of Correlogram
The function quickly decreases
to zero (a low ⍴)

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Correlogram and Stationarity

Preliminary Analysis: Estimation

ARIMA(1,1,1)
Command: ls ddividens c AR(1) MA(1)

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Empirical Example

Forecasting Monthly Electricity Sales

Total System Energy Demand

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Empirical Example (cont.)

Forecasting Monthly Electricity Sales

Correlogram for Monthly Electricity Sales Data

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Empirical Example (cont.)

Forecasting Monthly Electricity Sales Correlogram for 12-Month Differenced Data

(X t -X t-12 )

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Empirical Example (cont.)

Forecasting Monthly Electricity Sales

Box-Jenkins Forecast of System Energy
ARMA Order
AIC
RMSE
(1, 1)
1,930
320
(4, 1)
1,927
312
(1, 4)
1,926
311
(0, 4)
1,924
311
RMSE: Root mean squared error
Superior model:
ARIMA (0, 1, 4)

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Bibliography

● Brooks, C. (2008) Introductory Econometrics for Finance,

● Gujarati D.N., Porter D.C. (2004), Basic Econometrics,The McGraw−Hill Companies

● Maddala, G.S. (2002). Introduction to Econometrics.

● Ramanathan, R. (2002). Introductory econometrics with applications, Thomson Learning. Mason, Ohio, USA.

● Wooldridge,J. (2000) Introductory Econometrics: A modern Approach. South-Western College Publishing

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