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# Part 6: Dynamic models

3.1

## G[19], DM[13], K[18]

Distributed Lags

Distributed lags deal with the current and lagged effects of an independent variable
on the dependent variable. That is:
yt = + 0 xt + 1 xt1 + 2 xt2 + . . . + et
=+

i xti + et

i=0

## The effect of x on y is distributed over time:

The immediate effect is 0 (AKA impact multiplier);
The long-run effect over all future periods is

## i (AKA equilibrium mul-

tiplier);
The mean lag is

i=1

ii
P

j=0

i=1

iwi

The problem with the above model: an infinite number of coefficients. Two
feasible approaches are:
Assume i = 0 for i > some finite number.
Assume that i can be written as a function of a finite number of parameters
for all i = 1 to .

3.2

## Consider the model yt = + 0 xt + . . . + p xtp + t . No restrictions are placed on

the coefficients of the current and lagged values of x, but we need to decide on p.

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## October 24, 2007

t-tests are usually not good for selecting lag length because lagged values of x
are likely to be highly correlated with current values. i.e. t-tests will have low
power.
Two better approaches, both based on the assumption that you know some
upper bound P for the lag length:
2 or minimizes the Akaike Info.
Choose the lag length p P that maximizes R
 0 
Criterion (AIC) = ln eTe + 2p
T .
Start with high P and do F-tests for joint significance of i . Successively drop
lags. Stop dropping lags as soon as Ho : i = 0i is rejected.
Both methods tend to overfit (leave too many lags in), so high significance
levels should be used for the F-test (e.g. = .01).

3.3

## Geometric Lag models

Model have been used a great deal in the literature. They are two specific models
that imply a specific form of infinite distributed lag effects called Geometric lags.

3.3.1

Suppose the current value of the independent variables determines the desired value
or goal for the dependent variable:

yt = + xt + t ,

but only a fixed fraction of desired adjustment is accomplished in one period (it
takes time to build factories, restock diminished inventories, change institutional

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## yt yt1 = (1 )(yt yt1 );

|| < 1.

rearrange:
yt = (1 )1 (1 L)yt
replace yt with the r.h.s. above and rearrange:

(1 L)yt = (1 )( + xt + t )
yt = (1 ) + (1 )xt + yt1 + (1 )t
t + yt1 + t
=
+ x

## Intrinsically linear in parameters and disturbances uncorrelated if uncorrelated.

OLS is consistent and efficient.

3.3.2

## An Adaptive expectations model is based on a maintained hypothesis about how

expectations change. Example: When input decisions (supply decisions) are based
on expected future prices.
yt = + xt+1 + wt + t
xt+1 = xt + (1 )xt
xt is the expected value for xt evaluated at time t 1, and 0 < < 1. The second
equation implies that the change in expectations from t 1 to t is proportional to
the difference between the actual value of x in period t and last periods expectation
1. Rearrange the second equation to get xt+1 =
Page 93 WSU Econometrics II

(1)
(1L) xt .

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## 2. Substitute xt+1 out of the first equation to get

1
xt + wt + t
1 L

X
= + (1 )
i xti + wt + t

yt = +

i=0

= + zt () + wt + t ,

= (1 )

## this is in distributed lag form. Estimation proceeds recursively (as discussed in

Greene p. 568.) Briefly,
1. Constructed a variable zt () that satisfies zt () = xt + zt1 . Use z1 () =
x1 (1 ).
2. pick a set of s in (0,1), calculate z()s, include it as one of the variables in
separate OLS regressions.
that minimizes SSE.
3. Choose
4. Use computer search and/or optimization routines to do this.
Note that the disturbances satisfy the CLRM assumptions, and if they are i.i.d.
normal, this recursive process (that minimizes SSE) is also Maximum Likelihood).
The autoregressive form is

yt = +

(1 )
xt + t
(1 L)

t + w
t + yt1 + ut
yt =
+ x

## where ut = t t1 is a moving average error. Rather than the recursive approach

discussed above, you could also use Instrumental Variables approach (replace yt1 )
Page 94 WSU Econometrics II

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3.4

## The previous models are restrictive:

The geometric lag is very restrictive regarding the relative impact of different
lagged values of x.
Unrestricted lags truncate and eat up DF.
the ARDL is a more general form that can accommodate and approximate a huge
array of functional forms. An ARDL(p, r) is defined as

yt = +

p
X

i yti +

r
X

i=1

j xtj + t ,

i.i.d t

j=0

C(L)yt = + B(L)xt + t ,

where

C(L) = 1 1 L 2 L2 p Lp and
B(L) = 0 + 1 L + 2 L2 + + r Lr

3.4.1

Estimation

yt = yt1 + t

yt =
yt1 =

X
t
=
i ti
1 L
i=0

i ti

## (note index i starts at 1)

i=1

So, yt1 is a function of t1 and all previous disturbances. The CLRM assumption
of E[0 X] = 0 holds if is i.i.d. (in this case X is lag y), because yt1 is not

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## correlated with t . We can therefore consistently estimate . However, if t is a

function of past disturbances, then Cov[yt1 , t ] 6= 0. OLS Biased, inconsistent.
Show for yourself that Cov[yt1 , t ] 6= 0 for a model with one lagged dependent variable on the right and an AR(1) disturbance

3.4.2

## The equilibrium multiplier (long-run effect of a change in x) in the ARDL model

generally is

Pr
B(1)
i i
P
i =
Long Run multiplier =
= A(1) =
p
C(1)
1

i i
i=0
where A(L) =

B(L)
C(L) .

y =

B1 (1)
B2 (1)
Bk (1)
+
X1 +
X2 + +
Xk
C(1)
C(1)
C(1)
C(1)

## are constant values of y and Xi .

where y and X

0
(L)
The Mean Lag is AA(L)
.
L=1
3.4.3

## Calculating the lag coefficients

Consider an ARDL(2,1):
(0 + 1 L)
xt + t
(1 1 L 2 L2 )
B(L)
=
+
xt + t
C(L)

yt =
+

=
+ A(L)xt + t
=
+

i xt1 + t

i=0

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## i is the direct effect of xts on yt ; the coefficient on Li in A(L). Suppose we want

to calculate i .

A(L)C(L) = B(L)
(0 + 1 L + 2 L2 + . . . )(1 1 L 2 L2 ) = (0 + 1 L)

## Expanding this over a subset of A(L),

(0 0 1 L0 2 L2 )+(1 L1 1 L2 1 2 L3 )+(2 L2 2 1 L3 2 2 L4 )+ = 0 +1 L

L0 :

0 = 0

L1 :

0 1 + 1 = 1

L2 :

0 2 1 1 + 2 = 0

L3 :

1 2 2 1 + 3 = 0

## Rearranging each line respectively gives i as a function of the estimable parameters

i and i .

0 = 0
1 = 1 + 0 1

= 1 + 0 1

2 = 0 2 + 1 1

= 0 2 + (1 + 0 1 )1

3 = 1 2 + 2 1

= etc.

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3.4.4

## Forecasting with ARDL

Consider an ARDL(2,1):

yT +1 |yT = 1 yT + 2 yT 1 + 0 xT +1 + T +1
= 0 xT +1 + T +1 ,

where


xT +1 = yT

0
yT 1

xT +1

## Because E[T +1 ] = 0, yT +1 |yT is a consistent estimator of yT +1 |yT .

Var[e1 |T ] = E[0T +1 T +1 ]
= x0T +1 2 (X0 X)1 xT +1 + 2

## [be able to show this]

0
2
0
1
\
Var[e
xT +1 + s2 .
1 |T ] = xT +1 s (X X)

\
Var[e
1 |T ].

## Kalman Filter simplifies extended forecasting

Assume that T +1 is the only source of uncertainty.

yT +1

T +1

yT 0

=
+0
y
0
T 1

..
..

.
.
0

p1

0
..
.

p yT

T +1

0
yT 1

0 yT 2 +

0
.

..

..

.
0
yT p

T +1 =
T +1 + CyT + T +1
y

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## October 24, 2007

where
T +1 = + 0 xT +1 + + r xT +1r is known with certainty (so forecasts are
conditional on xT +1 ).

Cov[T +1 ] = E[(
yT +1 yT +1 )(
yT +1 yT +1 )0 ] =
0
.
..


where j = 1

2 0
0
= jj ,

.. . .
.
.


0

## 0 (which is a pp matrix) and Var[T +1 ] = Cov11 [T +1 ] =

2 .

Note:

The forecast errors T +i are included above for intuition about the forecast

## T +i , set T +i to its expected value

variance. When calculating the point estimates y
of zero.

For T+2:

T +2 =
T +2 + CyT +1 + T +2
y
T +2 + C(
T +1 + CyT + T +1 ) + T +2
=
T +2 + C
T +1 + C2 yT + (CT +1 + T +2 )
=
Cov[CT +1 + T +2 )] = 2 (Cjj0 C0 + jj0 )
and Var[
yT +2 ] is the upper left element of 2 (Cjj0 C0 + jj0 ).
For F periods out

(normalize T to T = 0):
F
X

F = CF y0 +
y

F (f 1) + F (f 1) ]
Cf 1 [

f =1

"
Var[
yF ] =

jj +

F
1
X

#
i

i 0

[C ]jj [C ]

i=1

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## October 24, 2007

Example: ARDL(2,1):

T +1 1
yT +1
+

=
1
0
yT

2 yT

yT 1
0

where
T +1 =
+ 0 xT +1 + 1 xT . Remember, for calculating forecasts, T +1 = 0.
3.4.5

## Common Factor restrictions

An AR(1) model
yt = xt + vt ;

vt = vt1 + t

can be written as
yt = yt1 + xt xt1 + t
which is an ARDL(1,1) with a restriction on the coefficient on xt1 .
AR(p) as a restricted ARDL(p,p):

## Let t be an i.i.d. disturbance.

yt = xt + vt ,
where vt = 1 vt1 + + p vtp + t
vt R(L) = t .
yt = xt +

t
R(L)

R(L)yt = R(L)xt + t
C(L)yt = B(L)xt + t for C(L) = B(L).

Implications
1. Any AR(p) disturbance in a static model can be interpreted as a restricted
version of an ARDL(p,p).

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## 2. Finding an AR(p) error process in your regression results can be an indication

of unaccounted-for ARDL process (i.e. a misspecified model).
E.g. an ARDL(2,2)model is

## Test for an AR(2) as a restricted ARDL(2,2) by testing the joint restriction

1 + 1 0 0
f (b) =
=
2 + 2 0
0
CFRs using characteristic roots.

## A more flexible and general method of test-

ing the specification of ARDL models is based on the roots of the Lag operator
polynomials.

C(L) = (1 1 L 2 L2 )
B(L) = 0 (1 1 L 2 L2 )

= (1 1 L)(1 2 L)
= 0 (1 1 L)(1 2 L)

where i and i are characteristics roots (note, we just arbitrarily changed the signs
of 1 , 2 ). Then the ARDL(2,2) can be written as

or

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## Now restrict 1 = 1 = (the lag operator polynomials have a common factor).

The model becomes an AR(1):

## (1 L)(1 2 L)yt = (1 L)(1 2 L)0 xt + t

(1 2 L)yt = (1 2 L)0 xt + ut

where ut =

t
1L

## Implications for estimation

1. The ARDL(2,2) has a white noise error, can be estimated consistently with
OLS.
2. The restricted model has a lagged dep. var and and AR(1) OLS is inconsistent.
Two possible approaches:
1. Estimate the unrestricted version (ARDL(p,r)); inefficient because the restriction is not imposed, but consistent.
2. Use IV with an instrument for the lagged dep. vars on right hand side; perhaps, for e.g., yt1 from a regression of yt on xt ...xtp .
Question:
3.4.6

## Error Correction Models (ECM)

ARDL(1,1):
subtract yt1 :

yt = + yt1 + 0 xt + 1 xt1 + t
yt = + ( 1)yt1 + 0 xt + 1 xt1 + t
yt = + ( 1)yt1 + 0 xt + (0 + 1 )xt1 + t

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## Then multiply (0 + 1 )xt1 by

1
1

to get


yt = + 0 xt + ( 1)(yt1 xt1 ) + t ,

, where

B(1)
C(1)

where =

0 + 1
1


=

B(1)
.
C(1)

## is the long-run multiplier we saw a while back. This is called an Error

correction model, or more precisely, the error correction form of the ARDL(1,1)
model. One more step:

yt = 0 xt + [yt1 (
+ xt1 )] + t

where
=

= 1
and = ( 1). yt is comprised of two components (plus

## disturbance): a short run shock from xt and a reversion toward equilibrium, or

equilibrium-error correction. To see this, note that in equilibrium yt = yt1 = y,
and xt = xt1 = x
, so yt = 0 and xt = 0. Then the ECM is

0 = [yt1 (
+ xt1 )],

so

y =
+
x

Therefore, yt1 (
+ xt1 ) represents deviation from the equilibrium relationship
y=
+ x. 1 = ( 1) is the marginal impact of this deviation on yt .
Estimation: Assuming stationarity of y, all parameter of the ECM can be calculated based on estimates from the original ARDL(1,1) model. Alternatively, all
parameters of the ARDL(1,1) model can be calculated with the parameters from
the alternative specification

yt = 0 + 1 xt + 2 yt1 + 3 xt1 + t

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## October 24, 2007

The results will be identical. Covariances can be calculated using the Delta method
if necessary. You could also estimate the ECM model parameters directly via nonlinear least squares.

3.5

Cointegration

## The problem: in general, a linear combination of variables will usually be

integrated to the highest order of the variables.
If any of the variables are I(d) with d > 0, then many or all parameter
estimates and associated t statistics may be biased. Consider the regression
yt = x0t + t . If x and y are integrated of different orders, then t = y x0t
will not be stationary.
The exception: if two or more of the series are integrated of the same order
drifting or trending at the same rate then we may be able to find a linear
combination of the variables that are I(0).
If so, we can consistently estimate parameters and use standard inference
statistics without having to difference or de-trend the variables.

3.5.1

## Consider two trending random variables: y1t = 3t + ut and y2t = t + vt , where vt

and ut are uncorrelated white noise errors. Both y1 and y2 are I(1), because their
first difference is stationary. Now consider the error process from a relationship

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## October 24, 2007

between y1 on y2 :

yit = y2t + t

y1t
= 1
y2t


t = y1t y2t

= (3t + ut ) (t + vt )
= (3 )t + (ut vt )

This is a linear combination of two I(1) variables, and so would in most cases
be I(1), and the variance if t would explode as t increases (i.e. not stationary).
However, if = 3, then the t is I(0) stationary, implying that y1 and y2
are cointegrated: integrated of the same order.

 

1 = 1 3 (or any multiple of it) is called a cointegrating vector
of y1t and y2t .
3.5.2

## The ARDL(1,1) model

yt = 0 wt + yt1 + 0 xt + 1 xt1 + t

can be written as

yt = 0 wt + 0 xt + (yt1 xt1 ) + t
yt = 0 zt + 0 xt + zt + t

## where zt = yt1 xt1 , = (0 + 1 )/( ), and = ( 1).

Page 105 WSU Econometrics II

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## October 24, 2007

If y and x are I(1), and wt are I(0), then is I(0) if zt = yt1 xt1 is
I(0).
Because is a function of the ARDL(1,1) parameters, a cointegrating relationship between the unrestricted ARDL parameters must hold for to be
stationary.
If such a relationship DOES hold, then will be stationary and we can estimate both the ARDL(1,1) form and the ECM form in a standard fashion
(OLS, NLS, with standard sampling distributions for the parameter estimates)
WITHOUT having to difference all the data.
If a cointegrating relationship does NOT hold, then the disturbance process
is not covariance stationary, and therefore the parameter estimates are not
covariance stationary, which means their sampling distributions are not stationary.
Note that when there is a cointegrating relationship, the regression above:

yt = 0 wt + 0 xt + zt + t

## is a regression of the I(0) variable yt on other I(0) variables.

Generally: If an ARDL(p,r) can be reparameterized as an ECM model with I(0)
variables, then the parameters on those I(0) variables can be estimated consistently
with OLS applied to the original ARDL(p,q) model, and the t-statistics on these parameter estimates are asymptotically standard normal. If in a reformulated (ECM)
regression only a subset of the parameters are associated with I(0) variables, this
subset of parameter estimates have standard sampling distributions. The others
dont.
The next question: How do we know if a cointegrating relationship exists between the two variables?
Page 106 WSU Econometrics II

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3.5.3

## Three approaches to testing for cointegrating vectors single equation approaches

and a multiple equation approach. We begin with the single equation approach and
discuss the multiple equation approach in the context of VARs.

## If two (or more) series are cointegrated

(or I(0)) in the context of then the errors in a regression of one on the others
will be associated with a disturbance series that is I(0) . The Engle-Granger
cointegration test Proceed as follows:
Calculate a DF test statistic based on the errors from your hypothesized
regression: That is, run the regression
t = t1 +vt , and calculate

se(
) .

This test statistic does not have the same distribution as the usual DF test
statistic. You need to compare it to a different set of critical values developed
by Davidson and MacKinnon (1993) (Not shown in Greene).
If a unit root is not rejected, then no cointegration and inference relating to
model parameters based on that model is suspect.
Differencing of one thing or another is likely called for.

3.6

## A VAR can be thought of as a reduced form for a system of dynamic equations.

Usefulness of the VAR framework:
Forecasting
Testing Granger Causality
characterizing the time path of effects of shocks (impulse response).

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## Figure 2: Engle-Granger critical Values

For two endogenous variables and known lag-length of p = 2, the VAR is a
two=equation model structured as:

## y1t = 1 + 111 y1t1 + 112 y2t1 + 211 y1t2 + 212 y2t2 + 1t

y2t = 2 + 121 y1t1 + 122 y2t1 + 221 y1t2 + 222 y2t2 + 2t
or

y1t 1 111
= +
y2t
2
121

112 y1t1 211

+
122
y2t1
221

212 y1t2 1t

+
222
y2t2
2t

or
yt = + 1 yt1 + 2 yt2 + t

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## October 24, 2007

Where jml is the coefficient for the j th lag in the mth equation on the lth endogenous
variable.
Estimation: VARs are systems of regression equations with interrelated errors, so
SUR seems appropriate. However, because there are no cross-equation restrictions,
SUR is mathematically equivalent to OLS equation by equation.
3.6.1

Granger Causality
yt = yt1 + xt1 + t

## If 6= 0 then x Granger-causes y in the regression above.

Granger causes y.
Granger causality of x on y is absent when f (yt |yt1 , xt1 , xt2 , ) = f (yt |yt1 );
This is a statistical relationship it does not imply causation in any sense
more general than this.
Example 19.8 (Greene), but extended to a VAR(2,2) here: increased oil prices have

0
preceded all but one recession since WWII. Let yt = GNP OIL PRICE .

GNP
t

1 1

= +
P OILt
2
1

2 GNPt1 3

+
2
P OILt1
3

4 GNPt2 1t

+
4
P OILt2
2t

## If 2 = 4 = 0 then changes in oil prices do not Granger cause changes in GNP;

otherwise it does.
testing for GC:

## H0 : 2 = 4 = 0. We can use a likelihood ratio test based on

first the restricted and unrestricted regressions of the first equation (GNP) alone; no
Page 109 WSU Econometrics II

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## October 24, 2007

need to estimate the second equation for this test. Test stat distributed 2 (J = 2).

3.6.2

## Impulse Response Functions

Impulse response functions track the effect of a single shock (from one or more
disturbance terms i ) on equilibrium values of y on the time path of y after the
shock.

y1t 1 111
= +
y2t
2
121

212 y1t2 1t

+
2t
222
y2t2

112 y1t1 211

+
122
y2t1
221

or
yt = + 1 yt1 + + p ytp + vt
(mx1)

(mx1)

(mxm) (mx1)

(mxm) (mx1)

(mx1)

For forecasting we can use the same Kalman filter arrangement as with the ARDL
Pp
model before: Recast the general model yt = + i i yti + vt as

yt1 0 I

. =.+ .
. . .
. . .

ytp+1
0
0
yt

0
..
.

0
yt2 0
. + .

0 .. ..

ytp
0
0

yt1

or
t =
+ (L)yt + vt .
y
let (L) = 1 L + 2 L2 , so that yt = + 1 yt1 + 2 yt2 + t can be written
as
yt = + (L)yt + vt .

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## Assuming a stable system (and leaving out the tildes),

[I (L)]yt = + vt
yt = [I (L)]1 ( + vt )
1

= [I (L)]

i vti

+
y

i vti

+ [I (L)]1 vt
y

## Note: for y to be stationary, we need [I (L)]1 to be nonsingular for this, all

eigenvalues must be less than one in absolute value (i.e. the moduli), whether or
not the eigenvalue(s) are real or complex. Note, the modulus of a complex number

h + vi is R = h2 + v 2 .
What we are interested in is how a one-time shock flows through to the yi,t+j . In
general, a set of impulse response function and its covariance matrix is calculated
as

T +s = y
+ s vT
y
T +s =

s1
X

i ( 0 )i

i=0

## where i is to the ith power.

Example: Suppose a first order VAR with = 0 for both equations in.

y1t 0.008
=
y2t
0.232

0.461 y1t1 v1t

+ ;
0.297 y2t1
v2t

## Page 111 WSU Econometrics II

1 .5
= Cov[v1t , v2t ] =

.5 2

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## October 24, 2007

Now, suppose a one unit change in v2t at t=0, such that v20 = 1. Then

y10 0
=
1
y20

0.461
y
0.008
0.461
y

10
11

=
=
0.297
0.232 0.297 y20
y21

2

y
0.008
0.461
y
0.008
0.461
y
0.141
12
11
10

=
=
=

y22
0.232 0.297 y21
0.232 0.297
y20
0.195
The covariance estimate for the two-period ahead impulse response is

1 .5 0.008
2 =

+
.5 2
0.232

0
0.461 1 .5 0.008 0.461

0.297 .5 2
0.232 0.297

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3.6.3

## Estimation of nonstationary cointegrated variables with VAR

VAR can be applied to a set of nonstationary variables are and cointegrated (see
Davidson and Mackinnon section 14.5).
Consider the VAR with g endogenous variables Yt :

Yt = Xt B +

p+1
X

Yti i + Ut

i=1

where Yt are I(1), Xt are assumed I(0) deterministic variables, and B and i are
matrices of parameters to be estimated. This VAR can be reparameterized as

Yt = Xt B + Yt1 +

p
X

Yti i + Ut

i=1

Pp+1
i=1

i Ig . This

## is the multivariate analogue of an augmented Dickey-Fuller test regression.

If the original variables Y are I(1) and the deterministic variables X are I(0),
then the rank r q of is equal to the number of cointegrating vectors. If r = 0,
there are no cointegrating vectors. r = g implies that all Y are stationary.
Note that the estimated value of will always be full rank (unless there is
perfect collinearity in the data to begin with, but then you wouldnt be able to run
a regression in the first place). The question is: can we test where our estimates
suggest one or more cointegrating vectors.

3.6.4

## Cointegration tests become potentially more complicated because for g variables

(Greene uses M ) in a VAR with I(0) variables, there can be up to g-1 cointegrating
vectors.
The Johansen test seems to be the most popular method for testing for cointegrating vectors in VARs. We will not go into detail about estimation, but there is
Page 113 WSU Econometrics II

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## a brief discussion in Greene p. 656-657 and in Davidson and MacKinnon.

1. We need to the number r of linearly independent cointegrating vectors embedded in . This is done with successive tests of Ho : there are r or fewer
cointegrating vectors, versus Ha : there are more than r cointegrating vectors
(up to g).
2. For each r starting with zero, a trace statistic or max statistic is calculated,
depending on the approach. These statistics are asymptotically 2 [g r]. Big
statistic reject Ho , and move on to next r. When statistics<critical value,
accept null.
Note that r > 1 implies more than one possible long-run relationship represented by a number of possible parameterizations. This is similar to the case of
an overidentified structural equation. Indeed, a VAR is in effect a reduced form of
a dynamic structural equation. To identify which cointegrating relationship holds
requires out-of-sample structural information (as in structural models themselves).

3.6.5

Structural VARs

## A VAR yt = + yt1 + vt can be seen as a reduced form of the structural model

yt = + yt1 + t
where = 1 , = 1 , t = 1 vt , and Cov[t ] = [ 1 ] [ 1 ]0 .
Thus, we are simply back to simultaneous equation systems, but with the issues of
dynamics and simultaneity combined.
Example: Suppose that

1
=
21
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12
.
1

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## October 24, 2007

Then we have a dynamic simultaneous equations problem, with all the lagged
dep. vars. being predetermined and therefore, for our purposes, exogenous.
Hsiao (1997) shows that if you have nonstationarity but cointegrating relationships in your model, then 2SLS and 3SLS can proceed as usual to address endogeneity.

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