Introduction to Econometrics

Lecture 8
Autocorrelation

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Econometric problems

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Topics to be covered
Overview of autocorrelation
First-order autocorrelation and the
Durbin-Watson test
Higher-order autocorrelation and the
Breusch-Godfrey test
Dealing with autocorrelation
Examples and practical illustrations
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Autocorrelated series and autocorrelated

disturbances

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Overview of autocorrelation
What is meant by autocorrelation The error terms are not
independent from observation to observation ut depends on one
or more past values of u
What are its consequences? The least squares estimators are
no longer efficient (i.e. they dont have the lowest variance).
More seriously autocorrelation may be a symptom of model
misspecification
How can you detect the problem? Plot the residuals against
time or their own lagged values, calculate the Durbin-Watson
statistic or use some other tests of autocorrelation such as the
Breusch-Godfrey test
How can you remedy the problem? Consider possible model
re-specification of the model: a different functional form,
missing variables, lags etc. If all else fails you could correct for
autocorrelation by using the Cochrane-Orcutt procedure or
Autoregressive Least Squares
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First-order autocorrelation

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The sources of autocorrelation

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The consequences of autocorrelation

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Detecting autocorrelation

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The Durbin-Watson test

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More on the Durbin-Watson statistic

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Using the Durbin-Watson statistic

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Durbin-Watson critical values

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The Breusch-Godfrey (LM) test

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The Breusch-Godfrey test continued

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Dealing with autocorrelation

How should you deal with a problem of autocorrelation?

Consider possible re-specification of the model:

a different functional form,
the inclusion of additional explanatory variables,
the inclusion of lagged variables (independent and
dependent)
If all else fails you can correct for autocorrelation by
using the Cochrane-Orcutt procedure or Autoregressive
Least Squares
INEMET [U13783]

Guy Judge March 2007