EC3304EconometricsII(2013/14SemI) TutorialAssignment5(forweeks12and13) ByTilakAbeysinghe Answerguide

2 1. Is yt inthefollowingprocessesstationary?Statewhyorwhynot?( ut ~ iid (0, u )

(i) yt = 1 + 0.9 yt 1 + ut Stationarybecausethecoefficientof yt 1 islessthanunity. (AlternativelyexpressthemodelinMAformandobtain E ( yt ) = 1/ (1 0.9) = 10 ,

Var ( yt ) = u2 / (1 0.9 2 ) 5.26 u2 , Corr ( yt , yt j ) = j = 0.9 j , j = 1, 2,.... donotdependon

time,t.) (ii) yt = 1 + 1.05 yt 1 0.05 yt 2 + ut Nonstationarybecause1.05+(0.05)=1whichthecaseofaunitrootor

(1 1.05 L + 0.05 L2 ) = 0 hasL=1asasolution(unitroot).

(iii) yt = 1 + 0.5yt 1 + ut Thisisstationaryinfirstdifferencesbecausethecoefficient0.5islessthanunity.But yt isa unitrootprocess,nonstationary, yt = 1 + 1.5 yt 1 0.5 yt 2 + ut . (iv) yt = a + bt + vt , vt = vt 1 + ut Nonstationarybecause yt hasadeterministictrendaswellasastochastictrendcoming throughtheunitrootin vt .Theunderlyingmodelisrandomwalkwithdrift. 2.ConsidertheARmodels:

yt = 0 + 1 yt 1 + 2 yt 2 + 3 yt 3 + ut

(1) (2)

yt = 0 + yt 1 + 1yt 1 + 2 yt 2 + ut
(i)

Showthat(2)isanequivalenttransformationof(1).

yt = 0 + ( 1 + 2 + 3 ) yt 1 2 yt 1 3 yt 1 + 2 yt 2 + 3 yt 3 + ut = 0 + ( 1 + 2 + 3 ) yt 1 ( 2 + 3 ) yt 1 + ( 2 + 3 ) yt 2 2 yt 2 + 3 yt 3 + ut yt = 0 + ( 1 + 2 + 3 1) yt 1 ( 2 + 3 )yt 1 3 yt 2 + ut

(ii) (iii)

WouldthestandarderroroftheregressionandRsquarebethesameforthetwomodels?

u2 isthesamebut R 2 willbedifferentbecausethedependentvariablesaredifferent.
Howdoyoutestthenullhypothesisthateachoftheslopcoefficientsof(2)iszero?

H 0 : = 0 isthesameas yt isaunitrootprocess.ThisisacaseofADFtest. H 0 : 1 = 0 and H 0 : 2 = 0 canbetestedusingstandardttest.

3.RefertotheexcelfileCPIPminIVLEEC3304workbin.Thisfilecontainsseasonallyadjusted quarterlytimeseriesofSingaporesconsumerpriceindex(CPI)andtheimportpriceindex(Pm).Lcpi andLpmdenotethelogofCPIandPmrespectively. (i) TestwhetherLcpiandLpmcanbecharacterizedasunitrootprocesses. EViewsoutputsaregivenbelow.Bothareunitrootvariables.
Null Hypothesis: LCPI has a unit root Exogenous: Constant Lag Length: 1 (Automatic - based on SIC, maxlag=12) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values. -0.061945 -3.481217 -2.883753 -2.578694 Prob.* 0.9502

Augmented Dickey-Fuller Test Equation Dependent Variable: D(LCPI) Method: Least Squares Date: 04/02/13 Time: 15:31 Sample (adjusted): 1980Q3 2012Q4 Included observations: 130 after adjustments Variable LCPI(-1) D(LCPI(-1)) C R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient -0.000202 0.568881 0.003034 0.338383 0.327964 0.005711 0.004142 488.5549 32.47700 0.000000 Std. Error 0.003260 0.070598 0.014701 t-Statistic -0.061945 8.058087 0.206368 Prob. 0.9507 0.0000 0.8368 0.005078 0.006966 -7.470076 -7.403902 -7.443187 1.961476

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat

Null Hypothesis: LPM has a unit root

Exogenous: Constant Lag Length: 2 (Automatic - based on SIC, maxlag=12) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values. -2.335655 -3.481623 -2.883930 -2.578788 Prob.* 0.1625

Augmented Dickey-Fuller Test Equation Dependent Variable: D(LPM) Method: Least Squares Date: 04/02/13 Time: 15:33 Sample (adjusted): 1980Q4 2012Q4 Included observations: 129 after adjustments Variable LPM(-1) D(LPM(-1)) D(LPM(-2)) C R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient -0.050553 0.298111 -0.246190 0.231331 0.158318 0.138118 0.020678 0.053450 319.3361 7.837394 0.000078 Std. Error 0.021644 0.084277 0.084865 0.099732 t-Statistic -2.335655 3.537270 -2.900955 2.319530 Prob. 0.0211 0.0006 0.0044 0.0220 -0.001632 0.022274 -4.888931 -4.800255 -4.852900 1.928451

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat

(ii) TestforGrangercausalitybetween Lcpit and Lpmt .(Setthelaglengthp=4.)Canyou assume Lpmt tobeanexogenousdeterminantof Lcpit ?(Notethat Lcpit .100and

Lpmt .100areapproximatelytheqoqconsumerpriceinflationandimportpriceinflation
respectively.ImportpriceiscomposedofforeigncurrencypriceofimportsandSin$exchange rate.)
Pairwise Granger Causality Tests Date: 04/02/13 Time: 15:36 Sample: 1980Q1 2012Q4 Lags: 4 Null Hypothesis: DLPM does not Granger Cause DLCPI DLCPI does not Granger Cause DLPM Obs 127 F-Statistic 2.23617 1.60358 Prob. 0.0692 0.1779

Grangercausalityisfromimportpriceinflationtoconsumerpriceinflation.Butthisisnota sufficientconditiontosaythat Lpmt isexogenous.Grangercausalitydoesnotshedlighton thecorrelationbetweencontemporaneousvariables,i.e., Lcpit and Lpmt .Itlooksatthe predictabilityof Lcpit basedon Lpmt j , j = 1, 2,... Youhavetoarguewhy Lpmt couldbe anexogenousdeterminantof Lcpit . (iii) ReestimateyourADLmodelbyincludingboththecontemporaneousandlaggedvaluesof

Lpmt intheregression.Droptheinsignificantlagsandarriveatsuitablemodel.Interpretthe
results.Howdoyouobtaintheforecastsof Lcpit usingthismodel?
Dependent Variable: DLCPI Method: Least Squares Date: 04/02/13 Time: 16:01 Sample (adjusted): 1980Q3 2011Q4 Included observations: 126 after adjustments Variable C DLCPI(-1) DLPM DLPM(-1) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient 0.002340 0.544259 0.056049 0.050424 0.402506 0.387814 0.005483 0.003668 479.2178 27.39539 0.000000 Std. Error 0.000606 0.070048 0.022611 0.023147 t-Statistic 3.865066 7.769839 2.478806 2.178386 Prob. 0.0002 0.0000 0.0145 0.0313 0.004939 0.007008 -7.543140 -7.453099 -7.506559 2.034433

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat

NoticeDLPMtisasignificantdeterminantofDLCPIt.ButthecoefficientsofDLPMtandDLPMt1 areverysmall.Singaporebeinganopeneconomyweexpectthesecoefficientstobelarge.Ifwe usethismodeleventogetonestepaheadforecastswehavetoforecastDLPMtfirst. 4. Considerthefollowingmodel Yt = 0 + 1 X te + ut wherethesuperscripteindicates

expectedoradesiredvalue.Thismayrepresentanexamplewhereconsumptiondepends onexpected,orpermanent,income. (i)Supposeexpectationsareformedasfollows: X te = X te1 + ( X t X te1 ); 0 < < 1 .Givean intuitiveexplanationforthisprocess.Hint: X t X te1 istheforecasterror.

Thisisoneofmanyformulationseconomistshavecomeupwithtoapproximate expectationformations.Expectationforthenextperiodisthesameasthe expectationforthisperiodiftherewasnoexpectationerrorthisperiod.Otherwise, expectationswillbeadjustedupordownbyafractionoftheexpectationerror.It wouldbemoremeaningfuliftheexpectationerrorwaswrittenas X t 1 X te1 .Itis writtenintheaboveformatsothat X t (insteadof X t 1 )appearsontheRHSofthe ADLmodel(seebelow).Thistypeofexpectationformationisknownasadaptive expectations.

(ii)Rewritetheexpectationsequationinthefollowingform: X te = (1 ) X te1 + X t .Either usingthelagoperatormethodorrepeatedsubstitutionexpress X te intermsofcurrent andpast X t .Explainwhytheaboveexpectationformationisknownasadaptive expectations.(Optional:whatisthedifferencebetweenadaptiveexpectationsand rationalexpectations?)

X te = (1 ) X te1 + X t X te = (1 L) 1 X t , where = 1 = (1 + L + 2 L2 + ....) X t

= X t + X t 1 + 2 X t 2 + ... Thisshowsthatexpectationsarebackwardlooking.Expectationsareanadaptation ofthepastintothefuture,thoughtheweightattachedtolagsdeclinegeometrically.

(Problemwiththisformulationisthatagentsmakesystematicerrorsinexpectation formations;agentsadjusttheirexpectationsupordownsystematically.Inrational expectationsagentsareforwardlookingandexpectationsareformedbasedona biggerinformationsetthanjustthepastvaluesofXandexpectationerrorsthey makeaveragetozero.) (iii)Substituting X te = (1 L ) 1 X t ,where = 1 ,into Yt = 0 + 1 X te + ut express the model as an ADL model that does not involve unobserved X te .Istheerrorprocess autocorrelatednow?CanweuseOLStoestimatethetransformedequation?Howdo youobtainthedynamicmultipliersfromthemodel?

Yt = 0 + 1 X te + ut = 0 + (1 L) 1 1 X t + ut (1 L )Yt = (1 ) 0 + 1 X t + (1 L)ut Yt = (1 ) 0 + Yt 1 + 1 X t + vt Yt = 0 + (1 )Yt 1 + 1 X t + vt

where vt = (1 L)ut = ut ut 1 ,MA(1)process,autocorrelated. Bywritingthelastequationaboveas Yt = 0 + 1Yt 1 + 2 X t + vt (a)

Theerrortermisautocorrelatedanditiscorrelatedwiththelaggeddependentvariable. AsaresulttheOLSestimatorisinconsistent.Wecanusetheinstrumentalvariable estimator.WealsoneedHACstderrors.Afterestimating(a)wecanobtaintheoriginal parametersfromthe estimates.ButdifficulttogetHACstandarderrorsforthe , , ). estimatesoforiginalparameters(

0 1

(Alternativelywecanobtainmaximumlikelihoodestimatesforthefullmodelincluding theMA(1)part,subjecttoparameterconstraints.)