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This example analyzes the importance of the monetary policy and its transmission mechanism in
the fast-growing Malaysian economy. The monetary model is:
M3 = f(Y, R, P) (1)
The data file is MacroM3.xls; where the dataset is covering from 1980M1 to 2008:M12.
Year M3 R P Y
1980M1 26281.8 3.49 46.1 12.54
1980M2 27301 3.59 46.21 12.61
1980M3 27926 3.66 46.28 13.22
1980M4 28721.9 3.75 46.13 13.56
1980M5 29483 4.1 46.49 13.72
1980M6 30130 4.17 46.86 12.93
1980M7 30747.6 4.14 47.36 14.06
1980M8 31157.6 4.14 47.78 13.29
1980M9 30864 4.26 47.62 13.95
1980M10 31272.7 4.33 47.89 13.83
1980M11 31906.4 4.47 48.54 13.56
1980M12 32687.6 4.46 48.94 13.39
1981M1 34458.1 4.42 49.78 13.06
: : : : :
: : : : :
: : : : :
2008M9 912780 3.56 114.73 105.04
2008M10 900443 3.55 114.23 104.35
2008M11 909231 3.38 112.93 100.38
2008M12 931656 3.02 111.83 95.92
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1. Open Eview 6 – File – New -- Workfile
2. Choose the frequency as Monthly – from 1980 M1 to 2008 M12 and then Click “OK”
2
4. Place your cursor to the left of the first row (obs)
3
7. Transform the variables into logarithm from [Type the following generate (genr)
command]:
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8. Checking for Unit Root – For example: lm3. Double click on “lm3”, click “View” and
choose the Unit Root Test.
9. We can choose Augmented Dickey Fuller (ADF) test and the optimal lag length is selected
by Akaike Information Criteria (large sample size).
i) First, we perform the unit root test of “lm3”: level model with constant but without
trend model (let say the maximum lag is 16) .
ii) Second, we perform the Unit root test again for the level model but now with
constant with trend model.
5
Eview Output for level Unit Root Test:
Constant without Trend Model:
Null Hypothesis: LM3 has a unit root
Exogenous: Constant
Lag Length: 16 (Automatic based on AIC, MAXLAG=16)
t-Statistic Prob.*
t-Statistic Prob.*
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Eview Output for First Different Unit Root Test:
t-Statistic Prob.*
t-Statistic Prob.*
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Eviews Output:
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Null Hypothesis: D(LM3) has a unit root
Exogenous: Constant, Linear Trend
Bandwidth: 8 (Newey-West using Bartlett kernel)
LR
LY
First Difference
LM3 -2.866** -3.0513 -16.6246*** -16.7362***
(14) (15) [9] [8]
LP
LR
LY
Note: *** and ** denotes significant at 1%, and 5% significance level, respectively. The figure in
parenthesis (…) represents optimum lag length selected based on Akaike Info Critirion. The figure in
bracket […] represents the Bandwidth used in the KPSS test selected based on Newey-West Bandwidth
critirion.
9
11. After testing the variables are stationary at first order or I(1), then the step is to estimate
the Vector Error-correction Model (VECM). Firstly, we need to select an optimum lag of
VECM model before performing the Johansen cointegration test.
10
12. From equation (1), the VECM model can be written as:
𝑗
∆𝐿𝑀31𝑡 = 𝜇1𝑡 − ∅1 (𝐿𝑀3 − 𝛾0 − 𝛾1 𝐿𝑌 − 𝛾2 𝐿𝑅 − 𝛾3 𝐿𝑃)𝑡−1 + ∑𝑖=1 𝛽1,𝑗 ∆𝐿𝑀31𝑡−𝑖 +
∑𝑗𝑖=1 𝛽2,𝑗 ∆𝐿𝑌1𝑡−𝑖 + ∑𝑗𝑖=1 𝛽3,𝑗 ∆𝐿𝑅1𝑡−𝑖 + ∑𝑗𝑖=1 ∆𝐿𝑃1𝑡−𝑖 + 𝜀1𝑡
(2)
𝑗
∆𝐿𝑌2𝑡 = 𝜇2𝑡 − ∅2 (𝐿𝑀3 − 𝛾0 − 𝛾1 𝐿𝑌 − 𝛾2 𝐿𝑅 − 𝛾3 𝐿𝑃)𝑡−1 + ∑𝑖=1 ∆𝐿𝑀32𝑡−𝑖 +
∑𝑗𝑖=1 ∆𝐿𝑌2𝑡−𝑖 + ∑𝑗𝑖=1 ∆𝐿𝑅2𝑡−𝑖 + ∑𝑗𝑖=1 ∆𝐿𝑃2𝑡−𝑖 + 𝜀2𝑡
(3)
𝑗
∆𝐿𝑅3𝑡 = 𝜇3𝑡 − ∅3 (𝐿𝑀3 − 𝛾0 − 𝛾1 𝐿𝑌 − 𝛾2 𝐿𝑅 − 𝛾3 𝐿𝑃)𝑡−1 + ∑𝑖=1 ∆𝐿𝑀33𝑡−𝑖 +
∑𝑗𝑖=1 ∆𝐿𝑌3𝑡−𝑖 + ∑𝑗𝑖=1 ∆𝐿𝑅3𝑡−𝑖 + ∑𝑗𝑖=1 ∆𝐿𝑃3𝑡−𝑖 + 𝜀3𝑡
(4)
𝑗
∆𝐿𝑃4𝑡 = 𝜇4𝑡 − ∅4 (𝐿𝑀3 − 𝛾0 − 𝛾1 𝐿𝑌 − 𝛾2 𝐿𝑅 − 𝛾3 𝐿𝑃)𝑡−1 + ∑𝑖=1 ∆𝐿𝑀34𝑡−𝑖 +
∑𝑗𝑖=1 ∆𝐿𝑌4𝑡−𝑖 + ∑𝑗𝑖=1 ∆𝐿𝑅4𝑡−𝑖 + ∑𝑗𝑖=1 ∆𝐿𝑃4𝑡−𝑖 + 𝜀4𝑡
(5)
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STEP 2.1: Select the Optimum Lag Length
LM3 LY LR LP
Change 2 to 1
(b) Make residuals for the VECM models, click “Proc” – “Make Residuals”
EViews will show 4 residuals in the EViews Workfile – resid01 (residual in Equation 1),
resid02 (residual in Equation 2), resid03 (residual in Equation 3), and resid04 (residual in
Equation 4).
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(c) Now, the autocorrelation of the error terms in each regression is checked by using the
Ljung-Box Q-statistic.
13
EViews Output:
The Q-statistic shows that the error terms are statistically significant from lag 12 for
“resid01”. This indicates that the model with lag 1 has autocorrelation problem. Hence, we
need to re-estimate the VECM model by increasing one lag (repeat the same process but
now with lag 2).
This process will continue until each of the regression error terms is free from
autocorrelation problem (where the p-values of Q-statistic are greater than 0.05).
In this case, we repeat the same process and the optimum lag is 12.
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13. The EViews output with 12 lag is as follows:
Long-run
Equation
Error
correction
terms
(ECT)
14. After obtaining the optimum lag, the next step is to estimate the Johansen Cointegration
Test. Click “View” – “Cointegration Test” – “OK”.
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0.05 represent 5%
significance level.
EViews Output:
16
Max-eigenvalue test indicates 1 cointegrating eqn(s) at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values
Table 2 presents the Johansen-Juselius Cointegration test. The result shows that both Trace
test and Max-Eigen test are statistically significant to reject the null hypothesis of r = 0 at
5% significance level. Therefore, only one long run cointegration relationship between M3
and it determinants.
If the model contains cointegration relationship among the variables, then we can proceed
to VECM and the long run equation is:
17
STEP 2.4: Granger causality test
15. After estimating the long-run VECM model, then we proceed to the short run Granger
causality test. Click “View” – “Lag Structure” – “Granger Causality/Block Exogeneity
Tests”.
EViews Output:
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Dependent variable: D(LP)
With Cointegration, the dynamic causal interactions among the variables should be phrased
in a vector error correction form. This allows us to assess both long-run and short-run
causality, respectively, on the 2 -test of the lagged first differenced terms for each right-
hand-side variable and the t-test of the error correction term. The results of the test are
presented in Table 3.
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Table 3: Granger Causality Results based on VECM
Independent Variables
Dependent 2 -statistics of lagged 1st differenced term ECTt-1
coefficient
[p-value]
Variable ΔLM3 ΔLP ΔLR ΔLY (t-ratio)
ΔLM3 30.23*** 14.72 21.51** -0.028**
-- [0.003] [0.257] [0.043] (-3.533)
LM3 LP
LY LR
20
STEP 2.5: Variance decomposition (VDC)
16. The result of VECM indicates the exogeneity or endogeneity of a variable in the system
and the direction of Granger-causality within the sample period. However, it does not
provide us with the dynamic properties of the system. The analysis of the dynamic
interactions among the variables in the post-sample period is conducted through variance
decompositions (VDCs) and impulse response functions (IRFs).
EViews Output:
Variance Decomposition of
LM3:
Period S.E. LM3 LP LR LY
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1 0.003904 0.057833 99.94217 0.000000 0.000000
2 0.006102 0.232518 99.30812 0.034317 0.425045
3 0.007787 0.493569 99.04644 0.076551 0.383441
4 0.009032 0.723986 98.88313 0.067843 0.325045
5 0.010067 1.013711 98.49578 0.206479 0.284028
6 0.010816 2.379293 96.86372 0.504991 0.251992
7 0.011544 4.710690 94.19444 0.867165 0.227708
8 0.012314 6.518148 91.82371 1.438480 0.219661
9 0.012968 7.566270 90.49069 1.743578 0.199466
10 0.013545 8.302143 89.10389 2.390148 0.203815
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STEP 2.6: Impulse response functions (IRFs)
17. Estimate the impulse response functions (IRFs), click “Estimate” and change the “Vector
Error Correction” to “Unrestricted VAR” and increase one more lag for the model from
lag 12 to lag 13.
Select “Impulse”
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Response to Cholesky One S.D. Innovations ± 2 S.E.
Response of LM3 to LM3 Response of LM3 to LP Response of LM3 to LR Response of LM3 to LY
.015 .015 .015 .015
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