Applied Econometric Methods I

Autocorrelation
Chapter 4.6-4.11

Stig Vinther Mller

Department of Economics and Business, Aarhus University

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Overview

OLS properties.
What is autocorrelation?
Consequences of autocorrelation.
Solutions.
Testing for autocorrelation.
Illustration: the demand for ice cream (In EViews).
Illustration: incomplete dynamics (EViews program).

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OLS properties

Under assumptions (A1) and (A2):

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The OLS estimator is unbiased. That is:

E fb g =

Under assumptions (A1), (A2), (A3) and (A4):

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The variance of the OLS estimator is given by:

V fb g = 2 X 0 X

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And s 2 is an unbiased estimator for 2 .

The OLS estimator is BLUE: best linear unbiased estimator for .

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The covariance matrix

Under the Gauss-Markov assumptions, the covariance matrix can be

written as:
2 2
3

0
0
6 0 2
0 7
7
6
7
6
2
7
6
V fe j X g = I = 6
7
7
6
5
4
0

2 is constant along the diagonal: (A3) is satised.

Zero o-diagonal elements: (A4) is satised.

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Autocorrelation

Autocorrelation (serial correlation) arises if dierent error terms are

correlated. This mostly occurs with time-series data.
When do we expect this?
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Model is missing seasonal patterns.

Model is based on overlapping samples (e.g. quarterly returns observed
each month).
Model is otherwise misspecied (omitted variable, incorrect dynamics,
etc.).

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Autocorrelation

The error term picks up the inuence of those (many) variables and
factors not included in the model.
If there is some persistence in these factors, autocorrelation may arise.
Thus, autocorrelation may be an indication of a misspecied model
(omitted variables, incorrect functional forms, incorrect dynamics).
Accordingly, autocorrelation tests are often interpreted as
misspecication tests.

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Autocorrelation
Demand for ice cream explained from income and price index

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Autocorrelation

Autocorrelation typically occurs with time series data (where

observations have a natural ordering).
To stress this, we shall index the observations by t = 1, ..., T rather
than i = 1, ..., N.

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First-order autocorrelation

Many forms of autocorrelation exist. The most common one is

rst-order autocorrelation.
Consider:
yt = xt0 + t
where the error depends upon its lagged value:
t = t

+ t

where t is an error term with mean zero and constant variance.

Assumptions are such that the Gauss-Markov conditions arise if = 0.

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Properties of the error term

To determine the properties of t , we assume jj < 1 (stationarity see

Ch. 8). Then it holds that:
E f t g = 0
and
2 = V ft g =

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2
1 2

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Properties of the error term

Further, the non-diagonal elements of the covariance matrix are:
2
1 2
2
cov ft , t 2 g = 2
1 2
2
cov ft , t s g = s
1 2

cov ft , t

1g

Thus, this form of autocorrelation implies that all error terms are
correlated. Their covariance decreases if the distance in time gets
large.
We see that if = 0, the non-diagonal elements of the covariance
matrix are equal to zero (no autocorrelation).

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Alternative autocorrelation patterns

We have shown that the model

yt = xt0 + t
where
t = t

+ t

implies that all errors are correlated with each other, with correlations
becoming smaller if they are further apart.
Two alternatives:
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Higher order patterns.

Moving average patterns.

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Higher order patterns

With quarterly or monthly (macro) data, higher order patterns are possible
(due to a periodic eect). For example, with quarterly data:
t = t

+ t

or, more generally:

t = 1 t

+ 2 t

+ 3 t

+ 4 t

+ t

known as 4th order autocorrelation.

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Moving average autocorrelation

Arises if the correlation between dierent error terms is limited by a

maximum time lag. Simplest case (1st order):
t = t + t
This implies that t is correlated with t
etc.

1
1,

but not with t

or t

3,

Moving average errors arise by construction when overlapping

samples are used (see the illustration in Section 4.11).

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Consequences

The consequences of autocorrelation is similar to the consequences of

heteroskedasticity.
As long as E fe j X g = 0 holds, the OLS estimator is still unbiased.
However, if V fe j X g = 2 I is violated: OLS is no longer BLUE.
Routinely computed standard errors are incorrect.

This also indicates three general ways to deal with the problem:
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Use alternative standard errors.

Use an alternative estimator (more e cient than OLS).
Reconsider the employed model (this option is often employed with
autocorrelation).

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Solution 1: Computing robust standard errors

Similar to the White standard errors for heteroskedasticity, it is also

possible to correct OLS standard errors for heteroskedasticity and
autocorrelation.
Newey and West have developed a method of computing consistent
standard errors in the presence of both heteroskedasticity and
autocorrelation of unknown form.
These standard errors are called
heteroskedasticity-and-autocorrelation consistent standard errors
(HAC standard errors) or Newey-West standard errors.
In EViews we have the option to choose Newey-West standard errors.

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Solution 1: Computing robust standard errors

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Solution 2: Deriving an alternative estimator

Trick: we know that OLS is BLUE under the Gauss-Markov
conditions.
Transform the model such that it satises the Gauss-Markov
assumptions again, i.e. transform the model to get uncorrelated
errors.
Then apply OLS to the transformed model. This leads to the
generalized least squares (GLS) estimator.
Transformation often depends upon unknown parameters
(characterizing the form of autocorrelation).
Estimate them rst and transform as before. This leads to a feasible
GLS (FGLS, EGLS) estimator.

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Solution 2: Deriving an alternative estimator

Consider:
yt = 1 + 2 xt + t
where the error depends upon its lagged value:
t = t

+ t

where t is an error term with mean zero and constant variance.

To transform the model such that it satises the Gauss-Markov
conditions we use:
yt

yt

= (1

) 1 + 2 (xt

xt

1 ) + t

With known , this produces (almost) the GLS estimator. Note: rst
observation is lost by this transformation.

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Solution 2: Deriving an alternative estimator

Of course, typically is unknown. How do we obtain an estimate of
?
First we can estimate the original model yt = 1 + 2 xt + t by OLS.
This gives the OLS residuals:
et

= yt
= yt

yt

(b1 + b2 xt )

Then starting from

t = t

+ t

it seems natural to estimate by regressing the OLS residual et upon

its lag et 1 .
We now use the estimate of which leads to estimated GLS (EGLS).

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Solution 3: Reconsider the employed model

Change functional form (e.g. use log(x ) rather than x), see Figure
4.5.
Extend the model by including additional explanatory variables
(seasonals) or additional lags.
In many cases, including lagged values of y and/or x will help
eliminate the serial correlation problem. We will see an example of
this below.

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Testing for rst-order autocorrelation

Asymptotic tests

By regressing the OLS residual et upon its lag et

estimate as well as a standard error to it.

1,

we obtain an

The resulting t-test statistic is approximately equal to:

p
T
t
where T is the number of observations in our sample.
We reject the null (no autocorrelation) against the alternative of
nonzero autocorrelation if jt j > 1.96 (95% condence).

Another form is based on (T 1) R 2 of this regression, to be

compared with a Chi-squared distribution with 1 DF (reject if > 3.86).

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Testing for rst-order autocorrelation

Asymptotic tests

Some remarks:
If we also suspect heteroskedasticity, White standard errors may be
used in the auxiliary regression.
If the model of interest contains lagged values of yt (or other
explanatory variables that may be correlated with lagged error terms),
the auxiliary regression should also include all explanatory variables
(just to make sure the distribution of the test is correct). This is
typically refered to the Breusch-Godfrey autocorrelation test. In the
BG test the origional regressors are always included in the auxiliary
regression:
et = et 1 + xt0 + t
The BG test is valid also in the case where the model does not
include lagged values of yt !
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Testing for rst-order autocorrelation

Durbin-Watson test

This is a very popular test, routinely computed by most regression

packages (also if it is not appropriate!).
Requirements:
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Intercept in the model.

Assumption (A2), so no lagged dep. variables!

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Testing for rst-order autocorrelation

Durbin-Watson test

The test statistic is given by:

dw =

Tt=2 (et et
Tt=1 et2

1)

This is approximately equal to:

dw

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Testing for rst-order autocorrelation

Durbin-Watson test

Distribution is peculiar.
Moreover, it depends upon xt s.
In general, dw values close to 2 are ne, while dw values close to 0
imply positive autocorrelation.
The exact critical value is unknown, but upper and lower bounds can
be derived (see Table 4.8).
Thus (to test for positive autocorrelation):
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dw is less than lower bound: reject.

dw is larger than upper bound: not reject
dw is in between: inconclusive.

The inconclusive region becomes smaller if T gets large.

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Testing for rst-order autocorrelation

Durbin-Watson test

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Testing for higher-order autocorrelation

Auxiliary regression in Breusch-Godfrey test:

et = 1 et

+ 2 et

+ ... + q et

+ xt0 + t

Null hypothesis:
H0 : 1 = 2 = ... = q = 0
Test statistic: (T
with q DF.

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q)

R 2 . Test follows Chi-squared distribution

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Illustration: the demand for ice cream

We have a time-series of 30 four-weekly observations 1951-1953.

Based on classic article Hildreth and Lu (1960).

See Figure 4.2 for three of these series.

EViews workle is available on Blackboard.

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Illustration: the demand for ice cream

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Illustration: the demand for ice cream

Command to run this regression: ls cons c price income temp

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Illustration: the demand for ice cream

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Illustration: the demand for ice cream

Regressing the OLS residuals upon their lag gives = 0.401 with an
R 2 of 0.149.
Run three commands in EViews:
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ls cons c price income temp

genr e=resid
ls e e(-1)

This gives test statistics:

p
(T

1)

T = 2.19
R 2 = 4.32

Both reject the null of no autocorrelation. Possible solutions:

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HAC standard errors.

EGLS.
Change model specication (see Table 4.11).
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Illustration: the demand for ice cream

Command to run this regression: ls cons c price income temp

temp(-1)
Does this model suer from autocorrelation?
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Illustration: incomplete dynamics

Consider the model
yt = 1 + 2 log xt + t
where
1 = 0
2 = 0.5
xt
t

= t
N (0, 0.01)

What happens if we use xt (instead of log xt ) to explain yt ?

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Illustration: incomplete dynamics

We simulate 1000 observations from the model:

create incomplete_dynamics u 1 1000
genr x =1+@trend
genr eps = 0.1*@rnorm
genr y = 0 + 0.5*log(x)+eps
Next, we regress y on a constant and x. Then we make a test for
autocorrelation.

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Summing up

We can test for autocorrelation using various tests.

In case our model suers from autocorrelation:
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Importantly, the OLS estimator is still unbiased.

However, the OLS standard errors are incorrect.

Possible solutions:
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Change model specication.

Use GLS/EGLS.
Use Newey-West standard errors.

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