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2. What are the consequences of autocorrelation? 3. How to detect autocorrelation in an application. 4. How to remedy the problem of autocorrelation. I. NATURE OF AUTOCORRELATION No autocorrelation assumption: cov(ui; uj) = 0 or E(ui,uj) = 0 Violation of no autocorrelation cov(ui; uj) 0 or E(ui,uj) 0 Patterns of auto and non-autocorrelation:
ij ij
1. Impure Autocorrelation Autocorrelation is caused by specification error such as omitted variable or an incorrect functional form. Omitted variable: True equation X2 omitted from the equation Yt= 0+ 1X1t+ 2X2t+ut Yt= 0+ 1X1t+vt vt = 2X2t+ut vt is not the classical error term. Instead, its a function of one of the independent variable, X2. vt can be autocorrelated even if the true error term ut is not Incorrect Functional Form: Correct model in a cost-output study Marginal costt=1+ 2.Outputt + 3.Outputt2+ut Estimated model Marginal costt=1+ 2.Outputt +vt The error term Vt= 3.Outputt2+ut vi contains the systematic effect of the output2 term on marginal cost vi will reect autocorrelation because of the use of an incorrect functional form
2. Pure Autocorrelation In a correctly specified equation. Caused by the underlying distribution of the error term in a truly specified equation. Often take place in time series applications.
Since cov(ut; ut+s) 0 or E(ut,ut+s) 0 (s 0) assume the mechanism that generate the error term ut.
Type of autocorrelation First-order autoregressive scheme AR(1): The current value of the error term is a function of the previous value of the error term u t = u t 1 + et where 1 < < 1 et is the stochastic error term which satisfies the standard OLS assumptions is the coefcient of autocovariance (or first-order autocorrelation coefficient) =0: no autocorrelation >0: positive autocorrelation <0: negative autocorrelation
Positive autocorrelation
ut = 1ut 1 + 2u t 2 + et
Pth order-autocorrelation scheme, AR(p):
ut = 1ut 1 + 2 ut 2 + ... + 2 ut p + et
II. CONSEQUENCES OF AUTOCORRELATION 1. Pure autocorrelation does not cause bias in the coefficient estimates but makes OLS no longer the minimum variance estimator.
80
60
40
20
uhat1
-20
-40
-60
Plot u t against u t 1
uhat1
uhat1_1
2. Durbin-Watson test
d=
(u
t =2
t =n
ut 1 ) 2
2 t
u
t =1
t =n
d 2(1 )
Since 1 1: Decisions:
0d 4
Important assumptions underlying the d statistic: 1. Regression model includes the intercept term. 2. Explanatory variables, the X s, are non-stochastic, or xed in repeated sampling. 3. Disturbances are generated by the rst-order autoregressive scheme
u t = u t 1 + et .
Cannot be used to detect higher order autoregressive schemes. 4. Error term is assumed to be normally distributed 5. Regression model does not include the lagged value(s) of the dependent variable as one of the explanatory variables 6. No missing observations in the data. 3. The Breusch-Godfrey LM Test (BG test) Used in large sample
Allow for: (1) nonstochastic regressors, such as the lagged values of the regressand; (2) higher-order autoregressive schemes, such as AR(1), AR(2), AR(p) Model
Yt = 1 + 2 X t + ut
Assume that the error term follows the p-order autoregressive, AR( p):
H 0 : 1 = 2 = ... = p = 0
Chi-squared version: 1. Estimate original model by OLS and obtain the residuals u t
2. Run and obtain R2 from
ut = 1 + 2 X t + 1ut 1 + 2 ut 2 + ... + p ut p + et
2 2 3. If (n p ) R > ( p ) then reject H0 , or autocorrelation of order p
ut = 1 + 2 X t + 1ut 1 + 2 ut 2 + ... + p ut p + et
2 3. Run and obtain R2 from
ut = 1 + 2 X t + et
2 ( R12 R2 ) / p > f ( p, n k * ) then reject H0, or autocorrelation of 4. If F = 2 * (1 R1 ) /( n k )
order p k* = number of regressors + p + 1 IV. REMEDIAL MEASURES FOR PURE AUTOCORRELATION Model
Yt = 1 + 2 X t + ut
Assume error term follows the AR(1) scheme Usually, we do not know 1. First Difference Method: As Maddala suggest, can be use when d<R2 Suppose =1
u t = u t 1 + et
Yt = 1 + 2 X t + ut Yt 1 = 1 + 2 X t 1 + ut 1
Subtraction Or Run a no-intercept model
Yt Yt 1 = 2 ( X t X t 1 ) + (ut ut 1 ) Yt = 2 X t + et
1
* Yt * = 1* + 2 X t + et
d 2
* where 1* = 1 (1 ) , et = u t u t 1 and 2 = 2
One observation lost because the rst observation has no prior Prais-Winsten transformation to retain the first observation: the rst observation on Y and X is transformed as follows:
Y1 1 2 and X 1 1 2
3. Estimated from the Residuals
ut = ut 1 + vt
Then use FGLS as in the previous method
4. Iterative Methods of Estimating
OLS but correct the standard errors for autocorrelation Only used in large samples