Solutions

1) (

(a) ∆ 4Yt

Answer: ∆ 4Yt = (1 − L4 )Yt = Yt − Yt −4 .

With quarterly data, this is the annual change. If Y is in logarithms, then this is
the annual growth rate.

(b) ∆ 2Yt

∆ 2Yt = (1 − L)2 Yt = (1 − 2 L + L2 )Yt = Yt − 2Yt −1 + Yt − 2

Answer:
= (Yt − Yt −1 ) − (Yt −1 − Yt − 2 ) = ∆Yt − ∆Yt −1

This represents the change of the change in a variable, or the “acceleration.” If

Y is in logarithms, then this is the quarterly change in the growth rate. A good
example would be the acceleration in the quarterly inflation rate.

(c) ∆1∆ 4Yt

∆1∆ 4Yt = (1 − L)(1 − L4 )Yt = (1 − L − L4 + L5 )Yt = Yt − Yt −1 − Yt −4 + Yt −5

Answer:
= (Yt − Yt − 4 ) − (Yt −1 − Yt −5 )

This is the quarterly change in the annual change. If Y is in logarithms, then this
is the quarterly acceleration or change in the annual growth rate.

(d) ∆ 24Yt

∆ 24Yt = (1 − L4 )2 Yt = (1 − 2 L4 + L8 )Yt = Yt − 2Yt −4 + Yt −8

Answer:
= (Yt − Yt − 4 ) − (Yt − 4 − Yt −8 ) = ∆4Yt − ∆4 Yt − 4

This represents the change in the annual change. If Y is in logarithms, then this
is the change in the annual growth rate.

2) Consider the standard AR(1) Yt = β 0 + β1Yt −1 + ut , where the usual assumptions hold.

(a) Show that yt = β1 yt −1 + ut , where yt is Yt with the mean removed, i.e., yt = Yt − E (Yt ) .

1
 Show that E ( yt ) = 0 .

Answer: E (Yt ) = β 0 + β1 E (Yt −1 ) , since E (ut ) = 0 . Therefore

Yt − E (Yt ) = β1[Yt −1 − E (Yt −1 )] + ut or yt = β1 yt −1 + ut . Now
yt = β1 yt −1 + ut = β1 ( β1 yt − 2 + ut −1 ) + ut = β12 yt −2 + ut + β1 ut −1 . Repeated
substitution then results in
n ∞
yt = β1n +1 yt −( n +1) + ∑ β1i ut −i , or as n → ∞, yt = ∑ β1i ut −i . Taking expectations on
i =0 i=0

both sides of the equation results in E ( yt ) = 0 , since

E (ut ) = E (ut −1 ) = ... = E (ut −n ) = ... = 0 .

3) Consider the following model

Yt = α 0 + α1 X te + ut

where the superscript “e” indicates expected values. This may represent an example
where consumption depended on expected, or “permanent,” income. Furthermore, let
expected income be formed as follows:

X te = X te−1 + λ ( X t −1 − X te−1 );0 < λ < 1

This particular type of expectation formation is called the “adaptive expectations

hypothesis.”
7,000,000.

(a) In the above expectation formation hypothesis, expectations are formed at the beginning
of the period, say the 1st of January if you had annual data. Give an intuitive explanation for this
process.

Answer: The term ( X t −1 − X te−1 ) is the forecast error for the previous period. If no
forecast error was made, then the forecast for the current period is the same as
for the previous period. If there was a forecast error, then the forecast for the
current period is adjusted by a fraction λ of that forecast error. Note also that
the adaptive expectations hypothesis can be rewritten as
X t = (1 − λ ) X t −1 + λ X t −1 ;0 < λ < 1 , in which case the expected value can be seen
e e

as a linear combination of the previous period’s forecast and the previous

periods actual value.

(b) Transform the adaptive expectation hypothesis in such a way that the right hand
side of the equation only contains observable variables, i.e., no expectations.

2
 X te = (1 − λ ) X te−1 + λ X t −1 = (1 − λ )[(1 − λ ) Xte−2 + λ Xt − 2 ] + λ Xt −1
Answer:
= (1 − λ ) 2 X te− 2 + λ X t −1 + λ (1 − λ ) X t − 2 .
Repeated substitution results in
n ∞
X te = (1 − λ )n +1 X tn−+(1n +1) + λ ∑ (1 − λ )i Xt −i −1 or, as n → ∞, X te = λ ∑ (1 − λ )i X t −i −1 .
i =0 i =0

(c) Show that by substituting the resulting equation from the previous question into the
original equation, you get an ADL(0, ∞ ) type equation. How are the coefficients of the
regressors related to each other?
∞
Answer: Yt = α 0 + α1 X t + ut = α0 + α1 (λ ∑ (1 − λ ) Xt −i −1 ) + ut or
e i

i =0

Yt = β 0 + β1 X t −1 + β 2 X t −2 + ... + βr Xt −r + ... + ut . Here α 0 = β 0 , and

β i = α1λ (1 − λ )i ; i ≥ 1 .

(d) Can you think of a transformation of the ADL(0, ∞ ) equation into an ADL(1,1) type
equation, if you allowed the error term to be ( ut − λ ut −1 )?

∞
Answer: Lagging both sides of Yt = α 0 + α1 (λ ∑ (1 − λ ) X t −i −1 ) + ut and multiplying both
i

i =0

sides by (1 − λ ) , results in
∞
(1 − λ )Yt −1 = α 0 (1 − λ ) + α1 (λ ∑ (1 − λ )i +1 Xt −i − 2 ) + (1 − λ )ut −1 . Finally, subtraction
i=0
∞
of this equation from Yt = α 0 + α1 (λ ∑ (1 − λ ) X t −i −1 ) + ut gives you
i

i =0

Yt = α 0 λ + α1λ X t −1 + (1 − λ )Yt −1 + (ut − (1 − λ )ut −1 ) .

3
 4) The following two graphs give you a plot of the United States aggregate unemployment
rate for the sample period 1962:I to 1999:IV, and the (log) level of real United States
GDP for the sample period 1962:I to 1995:IV. You want test for stationarity in both
cases. Indicate whether or not you should include a time trend in your Augmented
Dickey-Fuller test and why.

United States Unemployment Rate

12

10

2
65 70 75 80 85 90 95

U.S. Unemployment Rate

United States Real GDP (in logarithms)

9.0

8.8

8.6

8.4

8.2

8.0

7.8
65 70 75 80 85 90 95

LY92

Answer: Looking over the entire sample period, there does not appear to be a
deterministic trend for the unemployment rate. There is no need to include a
time trend for the ADF test in this case. The log level of real GDP, on the other
hand, is clearly upward trended and a time trend should therefore be included.

5) Show that the AR(1) process Yt = a1Yt −1 + et ;| a1 |< 1 , can be converted to a MA( ∞ )
process.

Answer: Yt = a1Yt −1 + et = a1 (a1Yt −2 + et −1 ) + et = a12Yt −2 + et + a1 et −1 . Repeated substitution

then results in Yt = a1 Yt −( n +1) + et + a1et −1 + ... + a1 et −n , and for n → ∞ ,
n +1 n

Yt = et + a1et −1 + ... + a1q et −q + ... .

The long-run, stationary state solution of an AD(p,q) model, which can be written as

4
 A( L)Yt = β 0 + c( L) X t −1 + ut , where a0 = 1 , and a j = − β j , c j = δ j , can be found by setting L=1
in the two lag polynomials. Explain. Derive the long-run solution for the estimated ADL(4,4) of
the change in the inflation rate on unemployment:

· Inf = 1.32 − .36∆ Inf − 0.34∆ Inf + .07 ∆ Inf − .03∆ Inf
∆ t t −1 t −2 t −3 t −4

−2.68Unempt −1 + 3.43Unempt −2 − 1.04Unempt −3 + .07Unempt −4

Assume that the inflation rate is constant in the long-run and calculate the resulting
unemployment rate. What does the solution represent? Is it reasonable to assume that this
long-run solution is constant over the estimation period 1962-1999? If not, how could
you detect the instability?

Answer: In a stationary state equilibrium, variables do not change from one period to the
next. Hence X t −1 = X t − 2 = ... = X t − q . This is achieved in the above formulation
by setting L=1. This solution represents the equilibrium rate of unemployment
or NAIRU. In the above example it is 6%. The NAIRU does not remain
constant but instead is a function of various determining variables such as
demographic composition of the labor force, the competitiveness of labor and
product markets, the generosity of the unemployment benefits system, etc. One
way to detect instability is to test for breaks, using a Chow-test, if the break
date is known, or using the QLR statistic, if the break date is unknown.

6) Consider the AR(1) model Yt = β 0 + β1Yt −1 + ut ,| β1 |< 1. .

(a) Find the mean and variance of Yt .

Answer: Rewrite the AR(1) model as follows

Yt = β 0 + β1Yt −1 + ut = β0 + β1 ( β0 + β1Yt −2 + ut −1 ) + ut
= β 0 (1 + β1 ) + β12Yt −2 + ut + β1 ut −1 .
Continuing the substitution indefinitely then results in
∞
Yt = β 0 (1 + β1 + β12 + β13 + ...) + ∑ β1i ut −i . Given the result for the sum of a
i =0
geometric series, the final expression is

β0 ∞
Yt = + ∑ β1i ut −i . To find the mean and the variance, take first expectations
1 − β1 i = 0

5
 β0 ∞
β
on both sides E (Yt ) = + ∑ β1i E (ut −i ) = 0 , since E (ut ) = 0 for all t.
1 − β1 i =0 1 − β1
∞
To derive the variance, note that Yt − E (Yt ) = ∑ β1 ut −i . Hence the variance is
i

i =0
∞ ∞
σ u2
E (Yt − E (Yt )) 2 = ∑ ( β1i )2 E (ut −i )2 = σ u2 ∑ ( β1i )2 = .
i =0 i =0 1 − β12

6
 (b) Find the first two autocovariances of Yt .

Answer: The first two autocovariances are defined as cov(Yt , Yt −1 ) and

β ∞
cov(Yt , Yt − 2 ) . Using the fact that Yt = 0 + ∑ β1i ut −i and that the expected
1 − β1 i = 0
values for both Yt and Yt − j , you get E[(Yt − E (Yt )(Yt −1 − E (Yt −1 )] =

∞ ∞
var(ut )( β1 + β13 + β15 + ...) = var(ut ) β1 (1 + β1 + β12 + ...)
E[(∑ β1i ut −i )(∑ β1i ut −i )] = σ u2
i=0 i =1 β1 .
1 − β1
σ u2 j σu
2

Similarly cov(Yt , Yt − 2 ) = β (and, more generally cov(Yt , Yt − j ) = β1

2
1
1 − β1 1 − β1
).

(c) Find the first two autocorrelations of Yt .

cov(Yt , Yt − j )
Answer: Since corr (Yt , Yt − j ) = , corr (Yt , Yt −1 ) = β1 and corr (Yt , Yt − 2 ) = β12
var(Yt )
(and, in general, corr (Yt , Yt − j ) = β1 .
j

7) Consider the following distributed lag model Yt = β 0 + β1 X t + β 2 X t −1 + ut , where

ut = φ1ut −1 + u%t , u%t is serially uncorrelated, and X is strictly exogenous.

How many parameters are there to be estimated between the two equations?

Answer: There are four parameters to be estimated, β 0 , β1 , β 2 and φ1 .

()b Using the two equations of the model

above, derive the ADL form of the model.

Answer: The ADL form of the model is derived by multiplying the first equation by φ1
and lagging it, then subtracting the resulting equation from the first equation,
and using the AR(1) equation of the error term for simplification of the
resulting specification.

Yt = β 0 + β1 X t + β 2 X t −1 + ut
−[φ1Yt −1 = φ1 β0 + φ1 β1 X t −1 + φ1 β2 X t − 2 + φ1 ut −1 ]

which, after collecting terms, results in

7
 Yt = β 0 (1 − φ1 ) + φ1Yt −1 + β1 X t + ( β2 − φ1 β1 ) Xt −1 − φ1 β2 Xt −2 + (ut − φ1 ut −1 )
or
Yt = α 0 + φ1Yt −1 + δ 0 X t + δ1 X t −1 + δ 2 Xt −2 + u%t .

()c There are five regressors in the ADL

model, namely Yt −1 , X t , X t −1 , X t − 2 and the
constant. Estimating the ADL model
linearly will give you five coefficients.
Can you derive the parameters of the
original two equation model from these
five estimates? Why or why not?

Answer: The original four parameters cannot be derived without restrictions since in
essence you have five equation in four unknowns.

()d What alternative method do you have to

retrieve the parameters of the two equation
model?

Answer: The above model can be specified in quasi-differences, i.e.,

(Yt − φ1Yt −1 ) = β 0 (1 − φ1 ) + β1 ( X t − φ1 Xt −1 ) + β2 ( Xt −1 − φ1 Xt −2 ) + u%t

or
Y° t = α 0 + β1 °X t + β 2 °X t −1 + u%t .

The parameters now can be estimated using nonlinear least squares, or

specifically, the Cochrane-Orcutt, or the iterated Cochrane-Orcutt estimator.

8) A model that attracted quite a bit of interest in macroeconomics in the 1970s was the St.
Louis model. The underlying idea was to calculate fiscal and monetary impact and long
run cumulative dynamic multipliers, by relating output (growth) to government
expenditure (growth) and money supply (growth). The assumption was that both
government expenditures and the money supply were exogenous. Estimation of a St.
Louis type model using quarterly data from 1960:I-1995:IV results in the following
output (HAC standard errors in parenthesis):

·ygrowth = 0.018 + 0.006 × dmgrowtht + 0.235 × dmgrowtht-1 + 0.344 × dmgrowtht-2

t
(0.004) (0.079) (0.091) (0.087)

+ 0.385 × dmgrotht-3 + 0.425 × mgrowtht-4 + 0.170 × dggrowtht – 0.044 × dggrowtht-1

(0.097) (0.069) (0.049) (0.068)

8
 - 0.003 × dggrowtht-2 – 0.079 × dggrowtht-3 + 0.018 × ggrowtht-4;
(0.040) (0.051) (0.027)

R 2 = 0.346, SER=0.03

where ygrowth is quarterly growth of real GDP, mgrowth is quarterly growth of real
money supply (M2), and ggrowth is quarterly growth of real government expenditures.
“d” in front of ggrowth and mgrowth indicates a change in the variable.

c. Assuming that money and government expenditures are exogenous, what do the
coefficients represent? Calculate the h-period cumulative dynamic multipliers from these.
How can you test for the statistical significance of the cumulative dynamic multipliers
and the long-run cumulative dynamic multiplier?

Answer: In that case the coefficients represent dynamic multipliers.

Lag number Monetary Monetary Fiscal Fiscal

Dynamic Cumulative Dynamic Cumulative
Multiplier Multiplier Multiplier Multiplier
0 0.006 0.006 0.170 0.170
1 0.235 0.241 -0.044 0.126
2 0.344 0.585 -0.003 0.123
3 0.385 0.970 -0.079 0.044
4 0.425 1.395 0.018 0.062

To test for the significance of the cumulative dynamic multipliers and the long-
run cumulative dynamic multiplier, the equation must be reestimated with all
regressors appearing in differences with the exception of the longest lag. The
coefficients of these regressors then represent cumulative dynamic multipliers
and t-statistics can be used to test for their statistical significance.

9
c. Sketch the estimated dynamic and cumulative dynamic fiscal and monetary multipliers.

Answer: See the accompanying figures.

Estimated Dynamic Multipliers

0.6

0.4
Multiplier

0.2

0
0 1 2 3 4

-0.2
Lag (in Quarters)

Monetary Dynamic Multiplier Fiscal Dynamic Multiplier

10
 Estimated Cumulative Dynamic Multipliers

1.6
1.4
1.2
1
Multiplier

0.8
0.6
0.4
0.2
0
0 1 2 3 4
Lag (in Quarters)

Cumulative Monetary Dynamic Multiplier

CumulativeFiscal Dynamic Multiplier

c. For these coefficients to represent dynamic

multipliers, the money supply and government
expenditures must be exogenous variables. Explain
why this is unlikely to be the case. As a result, what
importance should you attach to the above results?

Answer: There is little reason to believe that these government instruments are
exogenous. Even if the monetary base and those components of government
expenditures which do not respond to business cycle fluctuations had been chosen
rather than the above regressors, then these instruments respond to changes in the
growth rate of GDP. As a matter of fact, government reaction functions were also
estimated at the time to capture how government instruments respond to changes
in target variables. As a result, the regressors will be correlated with the error
term, OLS estimation is inconsistent, and inference not dependable. It is hard to
imagine how useable information can be retrieved from these numbers.

8) Your textbook used a distributed lag model with only current and past values of Xt–1
coupled with an AR(1) error model to derive a quasi-difference model, where the error
term was uncorrelated.

(a) Instead use a static model Yt = β 0 + β1 X t + ut here, where the error term follows
an
AR(1). Derive the quasi difference form. Explain why in the case of the infeasible GLS

11
 estimators you could easily estimate the β s by OLS.

Answer: The quasi-difference model is derived by multiplying the equation by φ1 and

lagging it, then subtracting the resulting equation from the first equation, and
using the AR(1) equation of the error term for simplification of the resulting
specification.

Yt = β 0 + β1 X t + ut
−[φ1Yt −1 = φ1 β0 + φ1 β1 X t −1 + φ1 ut −1 ]

which results in

Yt − φ1Yt −1 = β 0 (1 − φ1 ) + β1 X t − φ1 β1 Xt −1 + (ut − φ1 ut −1 ) .

Using the quasi-difference notation then yields

Y° t = α 0 + β1 °X t + u%t .

If φ1 was known, then it would be possible to generate the quasi-difference

variables in a statistical package and then estimate the coefficients using the
transformed variables using OLS.

(b) Since φ1 (the autocorrelation parameter for ut) is unknown, describe the Cochrane-Orcutt
estimation procedure.

Answer: In this case, nonlinear least squares has to be used to estimate the three
parameters. One possible feasible GLS estimator in this case is the Cochrane-
Orcutt estimator. In the first step, φ1 is set to zero, in which case β 0 and β1 can
be estimated by OLS. The resulting residuals are then used to calculate the OLS
estimator for φ1 . This, in return, can then generate the quasi-differenced
variables and OLS is then employed to get the estimate of β 0 and β1 .

(c) Explain how the iterated Cochrane-Orcutt estimator works in this situation. Iterations
stop when there is “convergence” in the estimates. What do you think is meant by that?

Answer: The iterated Cochrane-Orcutt estimator continues the process described in (a).
For example, in the next step, a new set of residuals is used to update the
previous estimate of φ1 , which will generate a new set of quasi-differenced
variables and new estimates of β 0 and β1 . The iterations stop when the
differences in the estimates from one round to the next differ by less than a very
small number, which can be chosen by the econometrician. This is then called
convergence.

12
(d) Your textbook has pointed out that the iterated Cochrane-Orcutt GLS estimator is in fact
the nonlinear least squares estimator of the model. Given that −1 < φ1 < 1 , suggest a “grid
search” or some strategy to “nail down” the value of φ$ which minimizes the sum of
1
squared residuals. This is the so-called Hildreth-Lu method.

Answer: Under the Hildreth-Lu method, the sum of squared residuals is computed for
various values of φ1 , using quasi-differenced variables. For example, initially a
coarse grid is chosen of –0.9, -0.8, -0.7, …, 0.7, 0.8, 0.9. For the value of φ1
which yields the smallest SSR, say 0.7, a new finer grid is chosen, such as 0.65,
0.66, 0.67, …, 0.73, 0.74, 0.75, and again the SSR is calculated for each of
these values. The value of φ1 which has the smallest SSR is retained and yet a
finer grid around it is chosen, etc.

9) Your textbook states that in “the distributed lag regression model, the error term ut can
be correlated with its lagged values. This autocorrelation arises, because, in time series
data, the omitted factors that comprise ut can themselves be serially correlated.”

(a) Give an example what the authors have in mind.

Answer: Taking the textbook example of the percentage change in the real price of
orange juice and the number of freezing degree days, the error term potentially
contains other variables such as change in tastes of the population, the price of
substitutes, income, etc. Some of these variables may be hard to measure, but
all of these are bound to change slowly over time and are not likely to be
correlated with the weather variable.

(b) Consider the ADL model, where the X’s are strictly exogenous, and there is no
autocorrelation (and/or heteroskedasticity) in the error term.

Yt = β 0* + β1 X t + β 2 X t −1 + β3Yt −1 + u%t

How many coefficients are there to be estimated? Show that this model can be
respecified using the lag operator notation:

φ ( L )Yt = β 0* + β1δ ( L ) X t + u%t

where, φ ( L ) = 1 − β 3 L. What is δ ( L) here?

β2 β2
Answer: (1 − β 3 L )Yt = β 0 + β1 (1 + L ) X t + u%t , so δ ( L ) = (1 +
*
L)
β1 β1

13
 β2
(c) Assume heroically that β 3 = − , i.e., that there is a “common factor” in the lag
β1
polynomials φ(L) and δ(L) Show that in this case the model becomes

Yt = β 0 + β1 X t + ut

β 0* 1 °
where β 0 = and ut = ut .
1 − β3 1 − β3 L

Answer: Dividing both sides by 1 − β 3 L results in the above equation after cancellation.

(d) Explain why autocorrelation in this model can be seen as a “simplification,” not a
“nuisance.” Can you use the F-test to test the above hypothesis? Why or why not?

Answer: There is one parameter less to estimate. The restriction is non-linear, so the F-
test does not apply here.

10) It has been argued that Canada’s aggregate output growth and unemployment rates are
very sensitive to United States economic fluctuations, while the opposite is not true.

(a) A researcher uses a distributed lag model to estimate dynamic causal effects of U.S.
economic activity on Canada. The results (HAC standard errors in parenthesis) for the
sample period 1961:I-1995:IV are:

·
urcan × × × ×
t = -1.42 + 0.717 urust + 0.262 urust-1 + 0.023 urust-2 - 0.083 urust-3
(0.83) (0.457) (0.557) (0.398) (0.405)

- 0.726 × urust-4 + 1.267 × urust-5 ; R 2 = 0.672, SER = 1.444

(0.504) (0.385)

where urcan is the Canadian unemployment rate, and urus is the United States
unemployment rate.

Calculate the long-run cumulative dynamic multiplier.

Answer: The long-run cumulative dynamic multiplier is 1.460.

14
 (b) What are some of the omitted variables that could cause autocorrelation in the error
terms? Are these omitted variables likely to uncorrelated with current and lagged values
of the U.S. unemployment rate? Do you think that the U.S. unemployment rate is
exogenous in this distributed lag regression?

Answer: Autocorrelation in the error term is the result of omitted variables which are
serially correlated. Canadian unemployment rates depend on Canadian labor
market conditions and most likely on Canadian aggregate demand variables in
the short run. Prime candidates for slowly changing omitted variables would be
demographics, indicators of unemployment insurance generosity, changes in the
terms of trade, monetary policy indicators such as the real interest rate, etc.
Some of these variables are highly likely to be correlated with U.S.
unemployment rates since demographics are similar between the two countries
and Canadian monetary policy often follows moves made by the Federal
Reserve. A case could be made that the U.S. unemployment rate is exogenous
as a result of the relative size of the two economies. However, due to the size of
the trade between the two countries, this is not as easy to support as if the
dependent variable were the unemployment rate in Costa Rica, say.

11) Consider the following model Yt = β 0 + β1 X te + ut where the superscript “e” indicates
expected values. This may represent an example where consumption depends on
expected, or “permanent,” income. Furthermore, let expected income be formed as
follows:
X te = X te−1 + λ ( X t − X te−1 ); 0 < λ < 1

(a) In the above expectation formation hypothesis, expectations are formed at the end of the
period, say the 31st of December, if you had annual data. Give an intuitive explanation for this
process.

Answer: If the forecast error for the previous period, ( X t − X te−1 ) was zero, then
expectations are not changed for the next period. If there was a non-zero
forecast error, then expectations are changed by a fraction of that forecast error.

(b) Rewrite the expectations equation in the following form:

X te = (1 − λ ) X te−1 + λ X t

Next, following the method used in your textbook, lag both sides of the equation and
replace X te−1 . Repeat this process by repeatedly substituting expression for X te− 2 , X te−3 ,
and so forth. Show that this results in the following equation:

X te = λ X t + λ (1 − λ ) X t −1 + λ (1 − λ ) 2 Xt − 2 + ... + λ (1 − λ )n Xt −n + (1 − λ )n +1 Xte− (n +1)

15
 Explain why it is reasonable to drop the last right hand side term as n becomes large.

Answer: Substitution of X te−1 = (1 − λ ) X te− 2 + λ X t −1 into X te = (1 − λ ) X te−1 + λ X t results in

X te = (1 − λ ) 2 X te− 2 + λ X t + (1 − λ )λ Xt −1 . The process is then repeated for X te− 2 ,
which gives X te = (1 − λ )3 X te−3 + λ X t + (1 − λ )λ Xt −1 + (1 − λ )2 λ Xt − 2 and so on.
The last term involving the unobservable expectation can be dropped for large n
since 0 < λ < 1 .

(c) Substitute the above expression into the original model that related Y to X te . Although
you now have right hand side variables that are all observable, what do you perceive as a
potential problem here if you wanted to estimate this distributed lag model without
further restrictions?

Answer: Yt = β 0 + β1 X te + ut =
β 0 + β1λ X t + β1λ (1 − λ ) X t −1 + β1 λ (1 − λ ) 2 Xt −2 + ... + β1 λ (1 − λ ) n Xt −n + ut .

For large n, this would require estimation of a large number of coefficients,

potentially more than there are observations available on lags of X.

(d) Lag both sides of the equation, multiply through by (1 − λ ) , and subtract this equation
from the equation found in (c). This is called a “Koyck transformation.” What does the
resulting equation look like? What is the error process? What is the impact effect (zero-
period dynamic multiplier) of a unit change in X, and how does it differ from long run
cumulative dynamic multiplier?

Answer: The Koyck transformation works as follows

Yt = β 0 + β1 λ X t +1 β λ )
(1 − −Xλ t 1 (1
1
2
+ β) λ X−−t 2λ... n
1 + ) + β X
(1 λt − uλt
n − +
+
− [(1 −λ Y)t −1 (1= −λ) 0 β 1 +β(1λ X) t −1λ 1−
2
(1 +β λ) X t 2 −λ ... n
−1 (1+ )+βX t λn n
1 −λ 1(1 − ) X +tβ n λ1 (1−λ u) t ]
1 −

which, after canceling terms results in

Yt = β 0 λ + β1 λX t(1 + ) − −Yλt 1 ut(1+ ) − u−t 1− λ

where β1λ (1 − λ ) n +1 X t − n−1 has been dropped using the same argument as above.
Note that there the error process is now a moving average. The impact effect is
β1λ , which is smaller than the long-run cumulative dynamic multiplier β1 ,
since 0 < λ < 1 .

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