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Vector Autoregressions (VARs): Granger Causality and Impulse Response Functions Granger Causality The VAR can be considered

as a means of conducting causality tests, or more specifically Granger causality tests. Granger causality really implies a correlation between the current value of one variable and the past values of others, it does not mean changes in one variable cause changes in another. By using a F-test to jointly test for the significance of the lags on the explanatory variables, this in effect tests for Granger causality between these variables. It is possible to have causality running from variable X to Y, but not Y to X; from Y to X, but not X to Y and from both Y to X and X to Y, although in this case interpretation of the relationship is difficult. The Granger causality test can also be used as a test for whether a variable is exogenous. i.e. If no variables in a model affect a particular variable it can be viewed as exogenous. Appropriate number of lags in the VAR The two most common methods for estimating the optimal lag length for a VAR, are the Akaike and Schwarz-Bayesian information criteria. In addition the usual diagnostic checks need to be made, to ensure the VAR is well specified. In particular the LM test for autocorrelation needs to be checked (the DW test can not be used with a VAR as it contains lagged dependent variables). If there is evidence of autocorrelation, more lags need to be added until the autocorrelation has been removed. Impulse Response Functions The impulse response functions can be used to produce the time path of the dependent variables in the VAR, to shocks from all the explanatory variables. If the system of equations is stable any shock should decline to zero, an unstable system would produce an explosive time path. Consider a basic VAR(1) model:

st = A1st 1 + ut
Where s is a stock price return, if we then assume a simple two stock price system, then the matrices and vectors in full would be:

s1t 0.2 0.1 s1t 1 u1t s = 0.0 0.3 s + u 2t 1 2t 2t


The next step is to calculate the value for each dependent variable, given a unit shock to the variable s1t at time t = 0 . The value of each dependent variable can be determined at t = 0,1,2,3 etc. In this case there is no effect in the s2t variable due to the way the model is set up, however if the s1t 1 variable had been significantly different to zero, then the shock would have affected both variables.

s1 = A1s0 u10 Where s0 = u 20


This implies that: s1 =

0.2 0.1 1 0.2 = 0.0 0.3 0 0.0

0.2 0.1 0.2 0.04 s2 = A1s1 = = 0.0 0.3 0.0 0.0 0.0008 s3 = A1s2 = 0.0
This process continue until the value of the dependent variable either becomes zero (stable) or very large (unstable). We could have done the same process with s2t , although in this case the dependent variable would have been affected by both explanatory variables, giving two separate time paths. Variance Decomposition This is an alternative method to the impulse response functions for examining the effects of shocks to the dependent variables. This technique determines how much of the forecast error variance for any variable in a system, is explained by innovations to each explanatory variable, over a series of time horizons. Usually own series shocks explain most of the error variance, although the shock will also affect other variables in the system. It is also important to consider the ordering of the variables when conducting these tests, as in practise the error terms of the equations in the VAR will be correlated, so the result will be dependent on the order in which the equations are estimated in the model. Vector Error Correction Models These are most associated with the VAR approach to cointegration, as before we can form the VECM, we need to ensure the variables are cointegrated, as with the bi-variate ECMs. There are other considerations though in this case, as if there is more then one cointegrating vector, we can in theory have more than one error correction term. However apart from this the VECM has the same properties as with the bi-variate ECM.

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