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Fundamentals of
Econometrics

Previous Two Weeks

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Week-13

Week-13

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Background

Background
▪ In statistics univariate summaries refers to Mean, Median, Mode, S.D,
Mean Deviation, Variance etc.
▪ …Bivariate summaries are required when there are two paired observations
(e.g., vehicle prices and their mileage per gallon) & interest is beyond
“univariate summaries”
▪ Such as ….how these two variables are linked …i.e., if one variable
increase/ decrease….what happens to other variable?
▪ A statistic that indicates how the two variables “co-vary” is called
“Covariance” and is given as:
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▪ 𝐶𝑂𝑉𝑋,𝑌 =
𝑛−1
σ𝑛𝑖=1(𝑋𝑖 − 𝑋)(𝑌
ത 𝑖 − 𝑌)ത

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Background (cont.…)
▪ E.g., if prices of vehicles (in 000s US$) and their mileage per gallon
(miles per gallon) are used and we calculate the covariance equal to -20
thousands of dollar-miles per gallon
▪ …it indicates that the two variables are negatively linked
▪ …however, it is difficult to interpret -20 thousands of dollar-miles per
gallon (quantitative Interpretation difficulty)
▪ …furthermore, the change in scale do influence the value of the
covariance
▪ This problems of Covariance are solved by making the Covariance
unitless measure.

Background (cont.…)
▪ As we saw from the formula of Covariance, that it was calculated as the
product of mean deviations of the two variable
▪ To make it unit less, Covariance is divide by the product of standard
deviations (SX, SY) of the same two variables…due to which the units of
numerators and denominator cancel out…we get dimensionless
number/ratio
▪ ….that is called correlation coefficient,
𝑛
represented by “r” and is given as:
𝐶𝑜𝑣𝑋,𝑌 ത 𝑖 − 𝑌)
σ𝑖=1(𝑋𝑖 − 𝑋)(𝑌 ത
𝑟𝑋,𝑌 = =
𝑆𝑋 𝑆𝑌 ത 2 σ(𝑌𝑖 − 𝑌)
σ(𝑋𝑖 − 𝑋) ത 2

✓ Correlation coefficient range between – 1 and +1 regardless of the unit of measurement

✓ When “r” value is +1 its called “Perfectly positive correlation”
✓ When “r” value is – 1 its called “Perfectly negative correlation”
✓ When “r” value is 0, its case of “no-correlation”
✓ Remember, correlation only measure the co-moment and linear correlation between two variables …does not
shows the causation between variables
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Autocovariance and Autocorrelation

▪ Autocovariance/Autocorrelation is same as Covariance/Correlation except
instead of two different variables it measures the co-moment for a single
“Time Series”
▪ We will focus on autocorrelation as its better measure compared to
Autocovariance as was the case for correlation compared to covariance
▪ Autocorrelation is the correlation between a variable lagged one or more
time periods and itself
▪ E.g., consider relationship of a time series Yt (observations in time t), with
another time series Yt-1 (observations of lag time period), this is called
Autocorrelation of Order 1.
▪ Similarly it could be Yt and Yt-2, or Yt-3 and so on ….i.e., the autocorrelation
of order 2, order 3 or higher order

Measurement of Autocorrelation
▪ For a time series (Yt) Autocorrelation can be calculated as follows:

σ𝑛𝑡=𝑘+1(𝑌𝑡 − 𝑌)(𝑌
ത 𝑡−𝑘 − 𝑌) ത
𝜌𝑘 =
ത 2
σ(𝑌𝑡 − 𝑌)
▪ 𝜌𝑘 value like correlation coefficients ranges between +1and -1 for perfect positive
and perfect negative autocorrelation/Serial Correlation*.
▪ Positive autocorrelation(negative autocorrelation) is the case when errors/time
series in one time period are positively correlated(negatively correlated) with the
same errors/time series in the other time period.
▪ Time series data patterns (Randomness, seasonality, trends etc.) can be studied
using Autocorrelation Coefficients
▪ The patterns can be identified using autocorrelation coefficient at different time
lags
*Although there is slight difference between autocorrelation and serial correlation, for this course we will treat them same and
will use it for correlation between succussive values of error terms.

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Lag-Values of a Variable

• You can
calculate Lag
values manually
as shown

• Software such as
EVIEWS you do
have an option to
generate lag
values directly

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Announcements
▪ Your Project is due at 17:00 hours on Wednesday, December 28, 2022

▪ Quiz 3 WILL be on Friday December 16, 2022, during class.

▪ Course: EViews till Heteroscadascity

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CHAPTER 6
Regression Diagnostic III: Autocorrelation

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Classical Linear Regression Model:

Assumptions (Old Slide)
▪ A-1: Model is linear in the parameters.
▪ A-2: Regressors (Xs) are fixed or non-stochastic.
▪ A-3: Given X, the expected value of the error term is zero, or E(ui
|X) = 0.
▪ A-4: Homoscedastic, or constant, variance of ui, or var(ui|X)= σ2
▪ A-5: No autocorrelation, or cov(ui,uj|X) = 0, i ≠ j.
▪ A-6: No multicollinearity, or no perfect linear relationships among
the X variables.
▪ A-7: No specification bias.

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Autocorrelation and Classical Linear

Regression Model (CLRM)
▪ One of the assumptions of the classical linear regression (CLRM)
is that the covariance between ui, the error term for observation i,
and uj, the error term for observation j, is zero i.e., cov(ui,uj|X) =
0, i ≠ j

▪ If this assumption of CLRM/OLS is violated we call it an issue

of Autocorrelation

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Causes of Autocorrelation

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Causes of Autocorrelation (Summary)

1. Inertia
2. Specification Bias (Excluded variable/incorrect functional form)
3. Cobweb Phenomenon
4. Lags
5. Manipulation of Data
6. Nonstationarity

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Causes of Autocorrelation: Inertia

▪ A salient feature of most economic time series is inertia, or sluggishness.
▪ E.g., time series such as GNP, price indexes, production, employment, and
unemployment exhibit (business) cycles.
▪ …when economy start recovery from a recession
▪ … most of these series start moving upward
▪ In this upswing, the value of a series at one point in time is greater than its
previous value.
▪ Thus there is a “momentum’’ built into them, and it continues until something
happens (e.g., increase in interest rate or taxes or both) to slow them down.
▪ Therefore, in regressions involving time series data, successive observations
are likely to be interdependent

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Causes of Autocorrelation: Specification Bias

Excluded Variable Case
▪ True Model: 𝑌𝑡 = 𝐵1 + 𝐵2 𝑋2𝑡 + 𝐵3 𝑋3𝑡 + 𝐵4 𝑋4𝑡 + 𝑢𝑡
▪ Estimated Model: 𝑌𝑡 = 𝐵1 + 𝐵2 𝑋2𝑡 + 𝐵3 𝑋3𝑡 + 𝑢𝑡
▪ Estimating the second equation implies that the error terms of X4t will be correlated
with error term i.e., 𝑢𝑡 = 𝐵4 𝑋4𝑡 + 𝑣𝑡
… and thus will result in an autocorrelation
Incorrect Functional Form
▪ True Model: 𝑌𝑡 = 𝐵1 + 𝐵2 𝑋2𝑡 + 𝐵3 𝑋2𝑡 2
+ 𝑢𝑡
▪ Estimated Model: 𝑌𝑡 = 𝐵1 + 𝐵2 𝑋2𝑡 + 𝑢𝑡
▪ Estimating the second equation implies that the error terms of 𝑋2𝑡2
will be correlated
with error term i.e.,
2
𝑢𝑡 = 𝐵2 𝑋2𝑡 + 𝑣𝑡
…and thus will result in an autocorrelation

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Causes of Autocorrelation: Cobweb Phenomenon

• Time 0: In Disequilibrium Market, Q1
Price (P)

output is Demanded, at High Price P1

S • Time Period 1…Farmers expect higher
prices…so they increase the Output to Q2
P1 …but at this level of Output… Price Falls
P3 to P2 when they try to sell their product due
to access supply
• As this process repeats itself i.e. between
periods of low supply with high prices and
then high supply with low prices, the price
P2 and quantity trace out a spiral.
• The economy converges to the equilibrium
D
where supply and demand intersect.
Q1 Q3 Q2 •
Quantity (Q) There is divergent model too. However,
these models itself is not the focus of the
Today Lecture or this course.
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Causes of Autocorrelation: Cobweb Phenomenon

▪ Consider a farmer, at the beginning of this Suppose there was high prices due to low supply
S
year’s planting of crops, farmers are Price (P)
influenced by the price prevailing last year. 2

(this phenomena is called cobweb

phenomenon) Pe 1 3

▪ In agricultural market, the supply reacts to

price with a lag of one time period because
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supply decisions take time to implement. D

▪ This is also one of the reason for 1. Low supply causes rise in price
Quantity (Q)

2. Rise in price cause high supply

Autocorrelation
3. High supply Cause fall in prices

4. Low prices causes fall in supply

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Causes of Autocorrelation: Lags

➢ Consider the following model
➢ 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛𝑡 = 𝐵1 + 𝐵2 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛𝑡−1 + 𝑢𝑡
➢ The above equation is known as autoregression because one of the
explanatory variables is the lagged value of the dependent variable.
➢ If you neglect the lagged the resulting error term will reflect a
systematic pattern due to the influence of lagged consumption on
current consumption.

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Causes of Autocorrelation: Manipulation of Data

▪ Different kind of manipulation may cause autocorrelation. For
example.
✓In empirical analysis, the raw data are often manipulated e.g.,
converting month to quarter or quarter to yearly data
✓Another source of manipulation is interpolation or
extrapolation of data.

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Causes of Autocorrelation: Nonstationarity

▪ A time series is stationary if its characteristics (e.g. mean, variance
and covariance) are time invariant; that is, they do not change over
time.
▪ When dealing with time series data, we should check whether the
given time series is stationary.
▪ Nonstationarity time series may have problem of autocorrelation

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Thank You

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