Lagged

AUTOCORRELATION IN A MODEL WITH A LAGGED DEPENDENT VARIABLE
Yt   1   2 X t   3Yt 1  u t
It has been mentioned in a previous sequence that, in a regression model where a lagged
dependent variable is one of the explanatory variables, OLS estimates will be subject to
some element of bias in small samples, even if u satisfies the Gauss-Markov conditions.
1
Yt   1   2 X t   3Yt 1  u t
This bias is generally considered not to be a serious problem and it is disregarded in

practice. In large samples the problem disappears.
2
Yt   1   2 X t   3Yt 1  u t
ut  ut 1   t
However, if the disturbance term is subject to autocorrelation, the situation is quite

different. OLS will yield inconsistent estimates. For example, suppose it is subject to AR(1)
autocorrelation, as shown above.
3
Yt   1   2 X t   3Yt 1  u t
ut  ut 1   t
Yt 1   1   2 X t 1   3Yt 2  ut 1
If the model is valid at time t, it must also be valid at time t-1.
4
Yt   1   2 X t   3Yt 1  u t
ut  ut 1   t
Yt 1   1   2 X t 1   3Yt 2  ut 1
Thus Yt-1 contains a random component ut-1, and so does ut. Therefore the fourth Gauss-
Markov condition is violated, and this automatically means that OLS yields inconsistent
estimates and that the standard errors and t and F tests are invalid.
5
Yt   1   2 X t   3Yt 1  u t
ut  ut 1   t
Yt 1   1   2 X t 1   3Yt 2  ut 1
n
h  ˆ
1  ns b2Y ( 1 )
When a lagged dependent variable is used as an explanatory variable, the Durbin-Watson

test for autocorrelation is inappropriate because the d statistic is biased towards 2.
6
Yt   1   2 X t   3Yt 1  u t
ut  ut 1   t
Yt 1   1   2 X t 1   3Yt 2  ut 1
n
h  ˆ
1  ns b2Y ( 1 )
Instead, one may use the Durbin h statistic to test for autocorrelation.
7
Yt   1   2 X t   3Yt 1  u t
ut  ut 1   t
Yt 1   1   2 X t 1   3Yt 2  ut 1
n
h  ˆ
1  ns b2Y ( 1 )
Three items are required for the test: an estimate of , the parameter in the AR(1) process,
n, the number of observations in the regression, and an estimate of the variance of the
coefficient of the lagged dependent variable.
8
Yt   1   2 X t   3Yt 1  u t
ut  ut 1   t
Yt 1   1   2 X t 1   3Yt 2  ut 1
n
h  ˆ
1  ns b2Y ( 1 )
d  2  2
ˆ  1  0.5d
There are several ways in which one might obtain an estimate of  However, the test is
strictly speaking valid only in large samples, and in large samples the different methods
should give similar results. It is easiest to exploit the relationship between d and .
9
n 35
h  ˆ h  0.14   0.86
1  ns b2Y ( 1 ) 1  35  0.0020
=============================================================
LS // Dependent Variable is LGHOUS
Sample(adjusted): 1960 1994
Included observations: 35 after adjusting endpoints
=============================================================
Variable Coefficient Std. Error t-Statistic Prob.
============================================================
C -0.390249 0.152989 -2.550839 0.0159
LGDPI 0.313919 0.052510 5.978243 0.0000
LGPRHOUS -0.067547 0.024689 -2.735882 0.0102
LGHOUS(-1) 0.701432 0.045082 15.55895 0.0000
=============================================================
R-squared 0.999773 Mean dependent var 6.017555
Adjusted R-squared 0.999751 S.D. dependent var 0.362063
S.E. of regression 0.005718 Akaike info criter -10.22102
Sum squared resid 0.001014 Schwarz criterion -10.04327
Log likelihood 133.2051 F-statistic 45427.98
Durbin-Watson stat 1.718168 Prob(F-statistic) 0.000000
=============================================================
Here is the output from a logarithmic regression of expenditure on housing services on
income and relative price, with a lagged dependent variable.
10
n 35
h  ˆ h  0.14   0.86
1  ns b2Y ( 1 ) 1  35  0.0020
=============================================================
=============================================================
============================================================
C -0.390249 0.152989 -2.550839 0.0159
LGDPI 0.313919 0.052510 5.978243 0.0000
LGPRHOUS -0.067547 0.024689 -2.735882 0.0102
LGHOUS(-1) 0.701432 0.045082 15.55895 0.0000
=============================================================
=============================================================
The Durbin-Watson statistic is equal to 1.72. Hence we obtain an estimate of (1 - 0.5x1.72) =
0.14 for  .
11
n 35
h  ˆ h  0.14   0.86
1  ns b2Y ( 1 ) 1  35  0.0020
=============================================================
=============================================================
============================================================
C -0.390249 0.152989 -2.550839 0.0159
LGDPI 0.313919 0.052510 5.978243 0.0000
LGPRHOUS -0.067547 0.024689 -2.735882 0.0102
LGHOUS(-1) 0.701432 0.045082 15.55895 0.0000
=============================================================
=============================================================
There were 35 observations in the regression. (There were 36 observations in the sample,
but the first could not be used because LGHOUS(-1) was not defined for it.)
12
n 35
h  ˆ h  0.14   0.86
1  ns b2Y ( 1 ) 1  35  0.0020
=============================================================
=============================================================
============================================================
C -0.390249 0.152989 -2.550839 0.0159
LGDPI 0.313919 0.052510 5.978243 0.0000
LGPRHOUS -0.067547 0.024689 -2.735882 0.0102
LGHOUS(-1) 0.701432 0.045082 15.55895 0.0000
=============================================================
=============================================================
The estimate of the variance of the coefficient of the lagged dependent variable is obtained
by squaring its standard error.
13
n 35
h  ˆ h  0.14   0.86
1  ns b2Y ( 1 ) 1  35  0.0020
=============================================================
=============================================================
============================================================
C -0.390249 0.152989 -2.550839 0.0159
LGDPI 0.313919 0.052510 5.978243 0.0000
LGPRHOUS -0.067547 0.024689 -2.735882 0.0102
LGHOUS(-1) 0.701432 0.045082 15.55895 0.0000
=============================================================
=============================================================
Hence the h statistic is 0.86. Under the null hypothesis of no autocorrelation, the h statistic
has a normal distribution with mean 0 and variance 1. This means that the critical value at
the 5% significance level is 1.96. We do not reject the null hypothesis in this case.
14
Yt = 10 + 0.8Yt-1 + ut ut = 0.7ut-1 + t
OLS AR(1)
Sample b1 b2 s.e.(b2) d h b1 b2 s.e.(b2) d h
1 4.7 0.95 0.07 1.14 2.50 17.3 0.79 0.10 2.05 -0.16
2 5.0 0.92 0.07 0.95 3.09 19.1 0.70 0.14 1.94 0.26
3 0.9 0.94 0.05 0.40 4.47 4.0 0.84 0.11 2.06 -0.20
4 6.1 0.84 0.11 0.89 3.68 14.2 0.65 0.15 1.50 2.32
5 5.1 0.83 0.07 1.11 2.60 8.5 0.75 0.13 2.09 -0.34
6 -1.7 1.01 0.05 1.04 2.70 5.0 0.91 0.09 2.01 0.03
7 5.3 0.90 0.08 0.78 3.65 17.4 0.71 0.13 1.93 0.27
8 -1.3 0.96 0.04 0.83 3.22 2.4 0.80 0.11 1.62 1.26
9 -0.6 0.98 0.04 0.55 4.01 3.8 0.83 0.10 1.83 0.54
10 -0.9 1.00 0.07 1.03 2.81 11.8 0.80 0.12 1.70 1.08
Here are the results of 10 replications of a Monte Carlo experiment illustrating the effects of
AR(1) autocorrelation in a model with a lagged dependent variable.
15
Yt = 10 + 0.8Yt-1 + ut ut = 0.7ut-1 + t
OLS AR(1)
1 4.7 0.95 0.07 1.14 2.50 17.3 0.79 0.10 2.05 -0.16
2 5.0 0.92 0.07 0.95 3.09 19.1 0.70 0.14 1.94 0.26
3 0.9 0.94 0.05 0.40 4.47 4.0 0.84 0.11 2.06 -0.20
4 6.1 0.84 0.11 0.89 3.68 14.2 0.65 0.15 1.50 2.32
5 5.1 0.83 0.07 1.11 2.60 8.5 0.75 0.13 2.09 -0.34
6 -1.7 1.01 0.05 1.04 2.70 5.0 0.91 0.09 2.01 0.03
7 5.3 0.90 0.08 0.78 3.65 17.4 0.71 0.13 1.93 0.27
8 -1.3 0.96 0.04 0.83 3.22 2.4 0.80 0.11 1.62 1.26
9 -0.6 0.98 0.04 0.55 4.01 3.8 0.83 0.10 1.83 0.54
10 -0.9 1.00 0.07 1.03 2.81 11.8 0.80 0.12 1.70 1.08
To keep the analysis as simple as possible, the model is very primitive. Y is determined
only by its lagged value, with intercept 10 and slope coefficient 0.8. The disturbance term is
subject to AR(1) autocorrelation with  equal to 0.7. The sample size is 30.
16
Yt = 10 + 0.8Yt-1 + ut ut = 0.7ut-1 + t
OLS AR(1)
1 4.7 0.95 0.07 1.14 2.50 17.3 0.79 0.10 2.05 -0.16
2 5.0 0.92 0.07 0.95 3.09 19.1 0.70 0.14 1.94 0.26
3 0.9 0.94 0.05 0.40 4.47 4.0 0.84 0.11 2.06 -0.20
4 6.1 0.84 0.11 0.89 3.68 14.2 0.65 0.15 1.50 2.32
5 5.1 0.83 0.07 1.11 2.60 8.5 0.75 0.13 2.09 -0.34
6 -1.7 1.01 0.05 1.04 2.70 5.0 0.91 0.09 2.01 0.03
7 5.3 0.90 0.08 0.78 3.65 17.4 0.71 0.13 1.93 0.27
8 -1.3 0.96 0.04 0.83 3.22 2.4 0.80 0.11 1.62 1.26
9 -0.6 0.98 0.04 0.55 4.01 3.8 0.83 0.10 1.83 0.54
10 -0.9 1.00 0.07 1.03 2.81 11.8 0.80 0.12 1.70 1.08
In all 10 samples the OLS estimate of the slope coefficient is above the true value, evidence
of positive bias.
17
Yt = 10 + 0.8Yt-1 + ut ut = 0.7ut-1 + t
OLS AR(1)
1 4.7 0.95 0.07 1.14 2.50 17.3 0.79 0.10 2.05 -0.16
2 5.0 0.92 0.07 0.95 3.09 19.1 0.70 0.14 1.94 0.26
3 0.9 0.94 0.05 0.40 4.47 4.0 0.84 0.11 2.06 -0.20
4 6.1 0.84 0.11 0.89 3.68 14.2 0.65 0.15 1.50 2.32
5 5.1 0.83 0.07 1.11 2.60 8.5 0.75 0.13 2.09 -0.34
6 -1.7 1.01 0.05 1.04 2.70 5.0 0.91 0.09 2.01 0.03
7 5.3 0.90 0.08 0.78 3.65 17.4 0.71 0.13 1.93 0.27
8 -1.3 0.96 0.04 0.83 3.22 2.4 0.80 0.11 1.62 1.26
9 -0.6 0.98 0.04 0.55 4.01 3.8 0.83 0.10 1.83 0.54
10 -0.9 1.00 0.07 1.03 2.81 11.8 0.80 0.12 1.70 1.08
As a consequence, the estimates of the intercept are biased downwards.
18
Yt = 10 + 0.8Yt-1 + ut ut = 0.7ut-1 + t
OLS AR(1)
1 4.7 0.95 0.07 1.14 2.50 17.3 0.79 0.10 2.05 -0.16
2 5.0 0.92 0.07 0.95 3.09 19.1 0.70 0.14 1.94 0.26
3 0.9 0.94 0.05 0.40 4.47 4.0 0.84 0.11 2.06 -0.20
4 6.1 0.84 0.11 0.89 3.68 14.2 0.65 0.15 1.50 2.32
5 5.1 0.83 0.07 1.11 2.60 8.5 0.75 0.13 2.09 -0.34
6 -1.7 1.01 0.05 1.04 2.70 5.0 0.91 0.09 2.01 0.03
7 5.3 0.90 0.08 0.78 3.65 17.4 0.71 0.13 1.93 0.27
8 -1.3 0.96 0.04 0.83 3.22 2.4 0.80 0.11 1.62 1.26
9 -0.6 0.98 0.04 0.55 4.01 3.8 0.83 0.10 1.83 0.54
10 -0.9 1.00 0.07 1.03 2.81 11.8 0.80 0.12 1.70 1.08
Despite the fact that it is biased towards 2, the Durbin-Watson statistic provides a warning
of severe positive autocorrelation.
19
Yt = 10 + 0.8Yt-1 + ut ut = 0.7ut-1 + t
OLS AR(1)
1 4.7 0.95 0.07 1.14 2.50 17.3 0.79 0.10 2.05 -0.16
2 5.0 0.92 0.07 0.95 3.09 19.1 0.70 0.14 1.94 0.26
3 0.9 0.94 0.05 0.40 4.47 4.0 0.84 0.11 2.06 -0.20
4 6.1 0.84 0.11 0.89 3.68 14.2 0.65 0.15 1.50 2.32
5 5.1 0.83 0.07 1.11 2.60 8.5 0.75 0.13 2.09 -0.34
6 -1.7 1.01 0.05 1.04 2.70 5.0 0.91 0.09 2.01 0.03
7 5.3 0.90 0.08 0.78 3.65 17.4 0.71 0.13 1.93 0.27
8 -1.3 0.96 0.04 0.83 3.22 2.4 0.80 0.11 1.62 1.26
9 -0.6 0.98 0.04 0.55 4.01 3.8 0.83 0.10 1.83 0.54
10 -0.9 1.00 0.07 1.03 2.81 11.8 0.80 0.12 1.70 1.08
Although the h test is a large-sample test, and we have only 29 observations in the
regressions, it does alert us to the presence of autocorrelation.
20
Yt = 10 + 0.8Yt-1 + ut ut = 0.7ut-1 + t
OLS AR(1)
1 4.7 0.95 0.07 1.14 2.50 17.3 0.79 0.10 2.05 -0.16
2 5.0 0.92 0.07 0.95 3.09 19.1 0.70 0.14 1.94 0.26
3 0.9 0.94 0.05 0.40 4.47 4.0 0.84 0.11 2.06 -0.20
4 6.1 0.84 0.11 0.89 3.68 14.2 0.65 0.15 1.50 2.32
5 5.1 0.83 0.07 1.11 2.60 8.5 0.75 0.13 2.09 -0.34
6 -1.7 1.01 0.05 1.04 2.70 5.0 0.91 0.09 2.01 0.03
7 5.3 0.90 0.08 0.78 3.65 17.4 0.71 0.13 1.93 0.27
8 -1.3 0.96 0.04 0.83 3.22 2.4 0.80 0.11 1.62 1.26
9 -0.6 0.98 0.04 0.55 4.01 3.8 0.83 0.10 1.83 0.54
10 -0.9 1.00 0.07 1.03 2.81 11.8 0.80 0.12 1.70 1.08
In the first sample we should reject the null hypothesis of no autocorrelation at the 5% level
(h > 1.96). In the other nine, we should reject the null hypothesis at the 1% level (h > 2.58).
21
Yt = 10 + 0.8Yt-1 + ut ut = 0.7ut-1 + t
OLS AR(1)
1 4.7 0.95 0.07 1.14 2.50 17.3 0.79 0.10 2.05 -0.16
2 5.0 0.92 0.07 0.95 3.09 19.1 0.70 0.14 1.94 0.26
3 0.9 0.94 0.05 0.40 4.47 4.0 0.84 0.11 2.06 -0.20
4 6.1 0.84 0.11 0.89 3.68 14.2 0.65 0.15 1.50 2.32
5 5.1 0.83 0.07 1.11 2.60 8.5 0.75 0.13 2.09 -0.34
6 -1.7 1.01 0.05 1.04 2.70 5.0 0.91 0.09 2.01 0.03
7 5.3 0.90 0.08 0.78 3.65 17.4 0.71 0.13 1.93 0.27
8 -1.3 0.96 0.04 0.83 3.22 2.4 0.80 0.11 1.62 1.26
9 -0.6 0.98 0.04 0.55 4.01 3.8 0.83 0.10 1.83 0.54
10 -0.9 1.00 0.07 1.03 2.81 11.8 0.80 0.12 1.70 1.08
If instead we use an AR(1) estimation method to fit the model, the estimates of 1 and 2 are
scattered randomly around their true values.
22
Yt = 10 + 0.8Yt-1 + ut ut = 0.7ut-1 + t
OLS AR(1)
1 4.7 0.95 0.07 1.14 2.50 17.3 0.79 0.10 2.05 -0.16
2 5.0 0.92 0.07 0.95 3.09 19.1 0.70 0.14 1.94 0.26
3 0.9 0.94 0.05 0.40 4.47 4.0 0.84 0.11 2.06 -0.20
4 6.1 0.84 0.11 0.89 3.68 14.2 0.65 0.15 1.50 2.32
5 5.1 0.83 0.07 1.11 2.60 8.5 0.75 0.13 2.09 -0.34
6 -1.7 1.01 0.05 1.04 2.70 5.0 0.91 0.09 2.01 0.03
7 5.3 0.90 0.08 0.78 3.65 17.4 0.71 0.13 1.93 0.27
8 -1.3 0.96 0.04 0.83 3.22 2.4 0.80 0.11 1.62 1.26
9 -0.6 0.98 0.04 0.55 4.01 3.8 0.83 0.10 1.83 0.54
10 -0.9 1.00 0.07 1.03 2.81 11.8 0.80 0.12 1.70 1.08
In nine of the ten samples, the h statistic is low enough for us not to reject the null
hypothesis of no autocorrelation. (With the fourth sample, we would make a Type I error, if
we used a 5% significance test.)
23
Yt = 10 + 0.8Yt-1 + ut ut = 0.7ut-1 + t
OLS AR(1)
1 4.7 0.95 0.07 1.14 2.50 17.3 0.79 0.10 2.05 -0.16
2 5.0 0.92 0.07 0.95 3.09 19.1 0.70 0.14 1.94 0.26
3 0.9 0.94 0.05 0.40 4.47 4.0 0.84 0.11 2.06 -0.20
4 6.1 0.84 0.11 0.89 3.68 14.2 0.65 0.15 1.50 2.32
5 5.1 0.83 0.07 1.11 2.60 8.5 0.75 0.13 2.09 -0.34
6 -1.7 1.01 0.05 1.04 2.70 5.0 0.91 0.09 2.01 0.03
7 5.3 0.90 0.08 0.78 3.65 17.4 0.71 0.13 1.93 0.27
8 -1.3 0.96 0.04 0.83 3.22 2.4 0.80 0.11 1.62 1.26
9 -0.6 0.98 0.04 0.55 4.01 3.8 0.83 0.10 1.83 0.54
10 -0.9 1.00 0.07 1.03 2.81 11.8 0.80 0.12 1.70 1.08
The standard errors of b2 are larger than those in the OLS regressions, but the latter were
invalid, so this is not a matter of concern.
24
Yt*   1   2 X t  ut Yt  Yt 1   (Yt*  Yt 1 )
Yt  Yt*  (1   )Yt 1
Yt   (  1   2 X t  ut )  (1   )Yt 1
  1   2 X t  (1   )Yt 1  ut
This sequence will conclude by looking at the implications of autocorrelation for the partial
adjustment and adaptive expectations models.
25
Yt*   1   2 X t  ut Yt  Yt 1   (Yt*  Yt 1 )
Yt  Yt*  (1   )Yt 1
Yt   (  1   2 X t  ut )  (1   )Yt 1
  1   2 X t  (1   )Yt 1  ut
In the partial adjustment model, the disturbance term in the fitted model is the same as that
in the target relationship, except that it has been multiplied by a constant, .
26
Yt*   1   2 X t  ut Yt  Yt 1   (Yt*  Yt 1 )
Yt  Yt*  (1   )Yt 1
Yt   (  1   2 X t  ut )  (1   )Yt 1
  1   2 X t  (1   )Yt 1  ut
Thus, if it satisfies the Gauss-Markov conditions in the target relationship, it will also satisfy
them in the fitted relationship. The only problem is the small-sample bias, and this is
disregarded in practice anyway.
27
Yt*   1   2 X t  ut Yt  Yt 1   (Yt*  Yt 1 )
Yt  Yt*  (1   )Yt 1
Yt   (  1   2 X t  ut )  (1   )Yt 1
  1   2 X t  (1   )Yt 1  ut
Of course, if the disturbance term in the target relationship is autocorrelated, it will be

autocorrelated in the fitted relationship. OLS would yield inconsistent estimates and you
should use some AR(1) estimation method instead.
28
Yt   1   2 X te1  ut X te1  X te   ( X t  X te )
Yt   1   2 X t   2  (1   ) X t 1   2  (1   )2 X t 2  ...
  2  (1   ) s1 X t  s1   2 (1   ) s X te s1  ut
In the case of the adaptive expectations model, we derived two alternative regression
models. One model expresses Y as a function of current and lagged values of X, enough
lags being taken to render negligible the coefficient of the unobservable variable Xet-s+1.
29
Yt   1   2 X t   2  (1   ) X t 1   2  (1   )2 X t 2  ...
  2  (1   ) s1 X t  s1   2 (1   ) s X te s1  ut
The disturbance term in the regression model is the same as that in the original model. So
if it satisfies the Gauss-Markov conditions in the original model it will do so in the
regression model, which should be fitted using a standard nonlinear estimation method.
30
Yt   1   2 X t   2  (1   ) X t 1   2  (1   )2 X t 2  ...
  2  (1   ) s1 X t  s1   2 (1   ) s X te s1  ut
If it is autocorrelated in the original model, it will be autocorrelated in the regression model.

An AR(1) estimation method should be used.
31
Yt   1   2 X t   2  (1   ) X t 1   2  (1   )2 X t 2  ...
  2  (1   ) s1 X t  s1   2 (1   ) s X te s1  ut
Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1
The other version of the regression model expresses Y as a function of X and lagged Y. The
disturbance term is a compound of ut and ut-1.
32
Yt   1   2 X t   2  (1   ) X t 1   2  (1   )2 X t 2  ...
  2  (1   ) s1 X t  s1   2 (1   ) s X te s1  ut
Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1
Thus if the disturbance term in the original model satisfies the Gauss-Markov conditions,
the disturbance term in the regression model will be subject to MA(1) autocorrelation (first-
order moving average autocorrelation).
33
Yt   1   2 X t   2  (1   ) X t 1   2  (1   )2 X t 2  ...
  2  (1   ) s1 X t  s1   2 (1   ) s X te s1  ut
Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1
Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2
If you compare the composite disturbance terms for observations t and t-1, you will see that
they have a component ut-1 in common.
34
Yt   1   2 X t   2  (1   ) X t 1   2  (1   )2 X t 2  ...
  2  (1   ) s1 X t  s1   2 (1   ) s X te s1  ut
Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1
Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2
The combination of moving-average autocorrelation and the presence of the lagged

dependent variable in the regression model causes a violation of the fourth Gauss-Markov
condition.
35
Yt   1   2 X t   2  (1   ) X t 1   2  (1   )2 X t 2  ...
  2  (1   ) s1 X t  s1   2 (1   ) s X te s1  ut
Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1
Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2
ut-1 is a component of both Yt-1 and the composite disturbance term. Thus the requirement
that the disturbance term be distributed independently of the explanatory variables is not
satisfied. Under these conditions, the other regression model should be used instead.
36
Yt   1   2 X t   2  (1   ) X t 1   2  (1   )2 X t 2  ...
  2  (1   ) s1 X t  s1   2 (1   ) s X te s1  ut
Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1
Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2
ut  ut 1   t
However, suppose that the disturbance term in the original model were subject to AR(1)
autocorrelation.
37
Yt   1   2 X t   2  (1   ) X t 1   2  (1   )2 X t 2  ...
  2  (1   ) s1 X t  s1   2 (1   ) s X te s1  ut
Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1
Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2
ut  ut 1   t
ut  (1   )ut 1  ut 1   t  (1   )ut 1
  t  (     1)ut 1
Then the composite disturbance term at time t will be as shown.
38
Yt   1   2 X t   2  (1   ) X t 1   2  (1   )2 X t 2  ...
  2  (1   ) s1 X t  s1   2 (1   ) s X te s1  ut
Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1
Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2
ut  ut 1   t
ut  (1   )ut 1  ut 1   t  (1   )ut 1
  t  (     1)ut 1
It is thus a composite of the innovation in the AR(1) process at time t and ut-1. Now, under
reasonable assumptions, both  and  should lie between 0 and 1. Hence it is possible that
the coefficient of ut-1 may be small enough for the autocorrelation to be negligible.
39
Yt   1   2 X t   2  (1   ) X t 1   2  (1   )2 X t 2  ...
  2  (1   ) s1 X t  s1   2 (1   ) s X te s1  ut
Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1
Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2
ut  ut 1   t
ut  (1   )ut 1  ut 1   t  (1   )ut 1
  t  (     1)ut 1
If that is the case, OLS could be used to fit the regression model after all. You should, of
course, perform an h test to check that there is no (significant) autocorrelation.
40

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AUTOCORRELATION IN A MODEL WITH A LAGGED DEPENDENT VARIABLE

This bias is generally considered not to be a serious problem and it is disregarded in

However, if the disturbance term is subject to autocorrelation, the situation is quite

If the model is valid at time t, it must also be valid at time t-1.

When a lagged dependent variable is used as an explanatory variable, the Durbin-Watson

As a consequence, the estimates of the intercept are biased downwards.

Of course, if the disturbance term in the target relationship is autocorrelated, it will be

If it is autocorrelated in the original model, it will be autocorrelated in the regression model.

Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1

Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1

Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1

Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2

Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1

Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2

The combination of moving-average autocorrelation and the presence of the lagged

Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1

Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2

Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1

Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2

Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1

Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2

Then the composite disturbance term at time t will be as shown.

Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1

Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2

Yt   1  (1   )Yt 1   2xt  ut  (1   )ut 1

Yt 1   1  (1   )Yt 2   2xt 1  ut 1  (1   )ut 2

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