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Primer on VARs and VECMs

A time series methodology

originating in macroeconomics [Sims

1980], now popular in finance soon

to take over your field too!

Dave Tufte's Primer on VAR's and VECM's 2

What do the acronyms stand for?

VAR: vector autoregression

Vector indicates the more than one variable will be

predicted

Thus, a set of regressions is run (simultaneously)

Autoregression indicates that variables will be

regressed on their own past values

VECM: vector error correction model

Simply a VAR with a specific type of coefficient

restriction imposed

Cointegration indicates whether those restrictions are useful

Dave Tufte's Primer on VAR's and VECM's 3

Whats the practical benefit of a

VAR?

How do you capture a relationship that

changes through time?

Probably not with a linear regression

However, a VAR, which amounts to a set of

inter-related linear regressions can do this

Dave Tufte's Primer on VAR's and VECM's 4

Example 1 from

Macroeconomics

Fisher Effect

Suppose the Federal Reserve pursues an

expansionary monetary policy essentially

they put new money into circulation

Interest rates drop in the short-run

Since the Fed buys bonds to get the money out

Interest rates rise in the long-run

Because the additional money in circulation allows the

prices of goods to be bid up

Dave Tufte's Primer on VAR's and VECM's 5

Example 2 from

Macroeconomics

The J-Curve

Suppose a country devalues their currency to

improve their trade position

GDP goes down in the short-run

Since prices of foreign intermediate products rise

immediately, production falls

GDP goes up in the long-run

Ultimately, domestic producers are able to adjust

quantities and export more at a low price

Dave Tufte's Primer on VAR's and VECM's 6

Whats the benefit to a researcher

of using a VAR?

A VAR requires less restrictive (easier to

justify) assumptions than other multi-

variable methods

It doesnt obviate the identification problem,

but it does:

Eliminate the linear algebra associated with it

Couch the problem in terms that are simpler for the

practitioner to apply

Dave Tufte's Primer on VAR's and VECM's 7

What do you need to choose to

set up a VAR?

A (small) set of variables

Six is about the upper limit

A decision on a lag length

The same length for each variable

Longer is preferable with this method

A decision about whether you need to

include any other deterministic variables

Like trends, dummies, or seasonal terms

Dave Tufte's Primer on VAR's and VECM's 8

What would the resulting VAR

look like?

A system of equations

One for each variable of interest

This VAR consists of two variables, 1 lag

(of each variable on the right hand side),

and a constant

x

t

= a

0

+ a

1

x

t-1

+ a

2

y

t-1

+ error

y

t

= b

0

+ b

1

x

t-1

+ b

2

y

t-1

+ error

Dave Tufte's Primer on VAR's and VECM's 9

How do you estimate the VAR?

(It can be proved that) there are no gains to

methods more complex than OLS, provided

that each equation has the same set of right

hand side variables

So, you could estimate this in Excel

Generally, you want to produce ancillaries

A specialized time series package like RATS, TSP,

or E-Views is worthwhile for this

Dave Tufte's Primer on VAR's and VECM's 10

What do the estimates of the

VAR look like?

You dont care

Personally, I rarely if ever even look at them

Dave Tufte's Primer on VAR's and VECM's 11

How is that justified?

When you estimate a parameter in a regression,

you estimate two things

The parameter itself

The standard error of the parameter

Omitting a relevant variable from the regression

biases the parameter and standard error estimates

You cant easily predict which way

Adding an irrelevant variable from the regression

biases the standard error estimate (upward)

But.the parameter estimate is fine

Dave Tufte's Primer on VAR's and VECM's 12

How is that justified (contd)?

With a VAR, when in doubt, you add extra

lags to the right hand side

This make sure that you dont omit anything

So, your parameter estimates are fine

However, you almost certainly included too

much

So, your standard errors go through the roof

As a result, your t-statistics are likely to indicate that

your parameters are insignificant

Dave Tufte's Primer on VAR's and VECM's 13

If youre not interested in the

significance of the parameters,

what is the point of estimating a

VAR?

VARs can be re-expressed as ancillaries

Impulse response functions

(Forecast error) variance decompositions

Historical decompositions

The last one is rarely used

Dave Tufte's Primer on VAR's and VECM's 14

Why do we need VAR

ancillaries?

There is a lot more going on in a simple VAR

system than meets the eye

x

t

= a

0

+ a

1

x

t-1

+ a

2

y

t-1

+ error

y

t

= b

0

+ b

1

x

t-1

+ b

2

y

t-1

+ error

Suppose y changes at t-1

Then x and y change at t

Both of which will cause x and y to change again at t+1

This process could continue forever, so you need a

way to sort those effects out and organize them

Dave Tufte's Primer on VAR's and VECM's 15

The math page 1

Write the system more specifically

x

t

= a

0

+ a

1

x

t-1

+ a

2

y

t-1

+ e

t

y

t

= b

0

+ b

1

x

t-1

+ b

2

y

t-1

+ h

t

Note that you can backshift the equations

x

t-1

= a

0

+ a

1

x

t-2

+ a

2

y

t-2

+ e

t-1

y

t-1

= b

0

+ b

1

x

t-2

+ b

2

y

t-2

+ h

t-1

Dave Tufte's Primer on VAR's and VECM's 16

The math page 2

Now substitute the right hand sides of the

backshifted equations for the right hand side

variables in the original equations to get:

x

t

= a

0

+ a

1

[a

0

+ a

1

x

t-2

+ a

2

y

t-2

+ e

t-1

] + a

2

[b

0

+

b

1

x

t-2

+ b

2

y

t-2

+ h

t-1

]

+ e

t

y

t

= b

0

+ b

1

[a

0

+ a

1

x

t-2

+ a

2

y

t-2

+ e

t-1

] + b

2

[b

0

+

b

1

x

t-2

+ b

2

y

t-2

+ h

t-1

]

+ h

t

Dave Tufte's Primer on VAR's and VECM's 17

The math page 3

These equations are a mess, but we can gather

terms to get:

x

t

= [a

0

+ a

1

a

0

+ a

2

b

0

] + [(a

1

)

2

+

a

2

b

1

]x

t-2

+ [a

1

a

2

+

a

2

b

2

]y

t-2

+ [e

t

+

a

1

e

t-1

+ a

2

h

t-1

]

y

t

= [b

0

+ b

1

a

0

+ b

2

b

0

] + [(b

1

a

1

+

b

1

b

2

]x

t-2

+ [b

1

a

2

+

(b

2

)

2

]y

t-2

+ [e

t

+

b

1

e

t-1

+ b

2

h

t-1

]

This is still a mess, but the essential point is that

each variable still depends on lags of both

variables, and a more complex set of errors

Dave Tufte's Primer on VAR's and VECM's 18

The math page 4

If we kept backshifting each equation and

substituting back in, wed ultimately get

equations that looked like this:

x

t

= constant + g

x

x

t-n

+ g

y

y

t-n

+ lots of errors

y

t

= constant + d

x

x

t-n

+ d

y

y

t-n

+ lots of errors

Note that the gs and ds, as well as the

errors would be big functions of all of the

as and bs from the original equations

Dave Tufte's Primer on VAR's and VECM's 19

How do we sort out whats going

on here?

One result that you can count on is that most of

the as and bs will be less than one in absolute

value

Only unstable processes will have a lot of as and bs

that are outside of this rang and we dont usually

think of our world as unstable

This is important because:

The gs and ds are composed of products of as and

bs which go to zero the more we backshift

The lots of errors are composed of sums of as and

bs weighting the errors which dont go to zero

Dave Tufte's Primer on VAR's and VECM's 20

The significance of the math

If we backshift enough, each series can be

shown to be equal to

A constant

Which is the mean of the variable

A (weighted) sum of past errors

These come from all variables

These are the shocks that buffet the variables

Dave Tufte's Primer on VAR's and VECM's 21

What do we do with this result?

We construct two VAR ancillaries to

summarize how and why a variable gets

away from its mean

Impulse response functions

These trace out how typical shocks will affect a

variable through time

Variance decompositions

Show which shocks are most important in

explaining a variable through time

Dave Tufte's Primer on VAR's and VECM's 22

Whats an impulse response

function?

Recall the error term obtained for x

t

on slide 17 (after one

backshift and substitution had been made)

e

t

+

a

1

e

t-1

+ a

2

h

t-1

The impulse response function is the pattern of how a

shock affects x it can be read off the coefficients

A shock to x (an e) affects x immediately, and continues to affect x

next period (the weight, a

1

may amplify or diminish the shock),

and stops affecting x after that

A shock to y (an h), does not affect x at all right away, affects it

with a weight of a

2

the next period, and stops affecting x after that

Dave Tufte's Primer on VAR's and VECM's 23

Whats a variance decomposition?

Once were done backshifting and substituting, whats left

is a constant plus errors

Any variance of the variable must come from those errors

But.the errors have a variance that we already know because it gets

estimated when we run the regression

Again, for x (after one backshift and substitution):

Var(x) = E[(e

t

+

a

1

e

t-1

+ a

2

h

t-1

)(e

t

+

a

1

e

t-1

+ a

2

h

t-1

)]

Var(x) = (s

e

)

2

+ (a

1

)

2

(s

e

)

2

+ (a

2

)

2

(s

h

)

2

Note that the first term is from t, and the last two are not

So, 100% of the variance of x at t comes from shocks to x (es)

However, the variance of x at t+1 comes from 2 sources

{(a

1

)

2

(s

e

)

2

/[(a

1

)

2

(s

e

)

2

+ (a

2

)

2

(s

h

)

2

]} from x

{(a

2

)

2

(s

h

)

2

/[(a

1

)

2

(s

e

)

2

+ (a

2

)

2

(s

h

)

2

]} from y

Dave Tufte's Primer on VAR's and VECM's 24

Reporting VAR ancillaries

Typically, the software produces a ton of numbers in

tabular form when you ask for these

The numbers are rarely reported

Generally, authors provide plots of both

An impulse response function graph shows you whether a shock to

one variable has:

A positive or negative affect on another variable (or both)

An effect the strengthens or diminishes through time

A variance decomposition graph shows you how the sources of

variation underlying a variables movements wax and wane through

time

Dave Tufte's Primer on VAR's and VECM's 25

Whats the biggest problem with

VAR ancillaries in published

research?

The ancillaries are non-linear combinations of a large

number of underlying parameter estimates

Unfortunately, parameters estimates are point estimates

They are correct with probability zero

So, all VAR ancillaries are also point estimates

How do we get around this?

It isnt very hard, and most programs can produce confidence

intervals for VAR ancillaries

So . whats the beef?

Many articles dont include these confidence intervals because

they are very wide indicating a lot of uncertainty in the results

Dave Tufte's Primer on VAR's and VECM's 26

Whats the catch?

At first glance, it seems like applying a VAR is nothing

more than applying some (time consuming) arithmetic to

plain old OLS regressions

This isnt the case. All multi-variable estimation problems

require the researcher to address something called the

identification problem

Prior to VARs (and still with other methods) this required solving

a sophisticated linear algebra problem

The difficulty of this problem goes up geometrically with the size of

the model youre working with

VARs still require that the identification issue be addressed, but

the question is couched in a form that is easier to tackle

The difficulty of this problem need not go up too quickly

Dave Tufte's Primer on VAR's and VECM's 27

Whats the identification problem?

Consider a basic microeconomic situation

We dont observe demand and supply

What we do observe is a quantity sold and a price

This is just one point on the standard microeconomics graph

At some other time, we may observe a different quantity

sold at a different price

This again is just another point on the graph

How did we get to that new point?

Did supply shift?

Did demand shift?

Did both shift?

This is the identification problem

Dave Tufte's Primer on VAR's and VECM's 28

How do we (conceptually) identify a

supply or a demand?

This is actually pretty easy

If only one of the curves shifts, the equilibrium will

move along the other curve tracing it out

In order to get only one curve to shift, it must be

pushed by some variable that only affects that

curve, and not the other one. For example:

Changes in personal income will cause demand to shift,

but are often irrelevant to the firms supply decisions

Changes in input prices will cause supply to shift but

are often irrelevant to the households demand decisions

Dave Tufte's Primer on VAR's and VECM's 29

How do we (mathematically)

identify a supply and a demand?

Write out an equation for each one. I assume that they each

relates prices and quantities, along with two other (shift)

variables R and S. For now, it is important to include both

of those variables in both equations

D: P = a

0

+ a

1

Q + a

2

R + a

3

S + demand error

S: P = b

0

+ b

1

Q + b

2

R + b

3

S + supply error

Identification amounts to saying that only one of R or S

affects demand, and the other one affects supply. This

amounts to the following restrictions:

a

2

= b

3

= 0, or alternatively

b

2

= a

3

= 0

Justifying restricting a whole bunch of parameters to zero

before you even start running regressions makes this tough

Dave Tufte's Primer on VAR's and VECM's 30

How does identification differ in

VARs? Part 1

Suppose you are trying to get information about how 2

variables, Y and Z, behave. First, you would right down a

system of 2 structural equations:

Y

t

= c

0

+ c

1

Z

t

+ c

2

Y

t-1

+ c

3

Z

t-1

+ m

t

Z

t

= d

0

+ d

1

Y

t

+ d

2

Y

t-1

+ d

3

Z

t-1

+ n

t

These equations are similar to those on the previous slide

I just replaced R and S with past values of Y and Z

These equations are structural in the sense that they contain

contemporaneous values of both variables of interest in

each equation

Also, because we are claiming that these represent some

underlying structure, we assume that the two errors are

uncorrelated

Dave Tufte's Primer on VAR's and VECM's 31

How does identification differ in

VARs? Part 2

All multi-variable estimations require that the structural

equations be estimated by first obtaining and estimating

the systems reduced form equations

Reduced forms are what is meant in algebra when you solve

equations two equations can be solved for two variables, in this

case y

t

and z

t

, in each case by eliminating the other variable from

the right hand side to get:

Y

t

= e

0

+ e

2

Y

t-1

+ e

3

Z

t-1

+ a function of both errors

Z

t

= f

0

+ f

2

Y

t-1

+ f

3

Z

t-1

+ another function of both errors

The es and fs will be some messy combination of the underlying

cs and ds from the structural equations

Dave Tufte's Primer on VAR's and VECM's 32

How does identification differ in

VARs? Part 3

We now have the original structural system:

Y

t

= c

0

+ c

1

Z

t

+ c

2

Y

t-1

+ c

3

Z

t-1

+ m

t

Z

t

= d

0

+ d

1

Y

t

+ d

2

Y

t-1

+ d

3

Z

t-1

+ n

t

10 things need to be estimated here: four cs, four ds and the

variances of the two errors (recall that their covariance is zero)

We also have the equivalent reduced form system:

Y

t

= e

0

+ e

2

Y

t-1

+ e

3

Z

t-1

+ a function of both errors

Z

t

= f

0

+ f

2

Y

t-1

+ f

3

Z

t-1

+ another function of both errors

When we estimate this we get 9 pieces of information about the 10

that we are trying to estimate above (three 3s, three fs, variances of

two errors, and one covariance between the - now related - errors)

Dave Tufte's Primer on VAR's and VECM's 33

How does identification differ in

VARs? Part 4

An alternative way of thinking about identification

is that we can only estimate as many structural

parameters as we have pieces of information from

the reduced forms

Thus, we have to eliminate one thing of interest in the

structural system

This may seem somewhat egregious, but recall that in the

economic example I gave that we had to restrict two

parameters to zero so we are already better off here!

Dave Tufte's Primer on VAR's and VECM's 34

How does identification differ in

VARs? Part 5

We can safely eliminate any of the ten parameters in the

structural system but we must eliminate some of them to

achieve identification

Heres where a VAR makes your life easier

Rather than constraining a parameter on two of the lags to zero, we

constrain one of the parameters on the contemporaneous terms to

zero

The former is tantamount to saying that particular variables from the

past do not cause other variables today

The latter is saying something less egregious that certain variables

dont affect other ones right away. This is an easier thing to explain

and justify.

Dave Tufte's Primer on VAR's and VECM's 35

How does VAR identification work

in practice?

Identifying a VAR amounts to choosing an

ordering for your variables

If you have n dependent variables, they can be

rearranged into n! orders

The researchers job is to pick one of those orders

What makes a good order?

An argument that one variable (say X) is likely to affect

some other variable (say Y) before Y can feed back and

affect X

Dave Tufte's Primer on VAR's and VECM's 36

An example of VAR identification

A common set of variables in a macroeconomic VAR

includes output, money, prices, and interest rates (Y, M, P,

and r)

There are 24 possible orderings

YMPr, YMrP, YPMr, YPrM, rPMY, and so on

A plausible ordering would be M, r, Y, P

The Federal Reserve controls M, and isnt likely to respond

quickly to the other variables

The Federal Reserve is trying to influence r

By influencing r, the Federal Reserve hopes to influence Y and P

Most first adjust quantities faster than prices, so I put Y before P

Dave Tufte's Primer on VAR's and VECM's 37

How sensitive are VARs to

ordering?

This question doesnt have a good answer

There are big differences across the set of possible

orderings, but a good researcher knows that most of

those orderings arent justifiable

A good convention to go by is that if you have

trouble figuring out which variable should precede

and which should follow, it probably wont make

much difference to the VAR ancillaries either

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