Error Correction Model Example

Cyrus Samii December 17, 2007

Intro

I work through the ECM example in Wooldridge, Introductory Econometrics. For this memo to make sense, be sure to review chapters 10,11, and 18 in the Wooldridge text rst. We use ECM to study dynamics when two or more variables are integrated with unit rootsi.e. follow some kind of random walkbut sustain some equilibrium relationship to each other. In such a case, we say that the variable are cointegrated. In the example in this memo, we study future returns on 6-month T-bills as a function of current returns on 3-month T-bills. See Problem 11.6 on p. 406 for a description of the variables and the theory, where the hypothesized relationship is E (hy6t |It1 ) = hy3t1 . The goal is to specify a proper model to test whether this hypothesized relationship is correct. First, obtain the INTQRT.RAW data le. You can do this by opening Stata and running use http://fmwww.bc.edu/ec-p/data/wooldridge/ We will rst perform the Engle-Granger two-step method.

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2.1

ECM via the Engle-Granger 2-Step Method

Test for Unit Roots

The rst thing we want to do is to determine whether either {hy3t } or {hy6t } have unit roots. We can use a Dickey-Fuller (DF) test to do so. 2.1.1 No lags, no trend

For {hy3t }, we run the following regression: hy3t = + hy3t1 + et ,

Department of Political Science and ISERP Statistical Consulting, Columbia University. cds81@columbia.edu.

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where = 1 . When = 1, the series has a unit root, so we want to test whether is signicantly dierent than 0. To do so, we check t-statistic for against the DF critical values (see Wooldridge, pp. 641-644). When we run reg chy3 hy3_1 we obtain = .09 and t = 2.47. Since this is less than the DF critical value at the 10% signicance level, we cannot reject the null hypothesis that = 0, in which case we cannot reject the null that {hy3t } has a unit root. 2.1.2 Lags, no trend

We can also run an augmented DF test to see whether the results change when we allow {hy3t } to follow an AR(1) process, that is, hy3t = + hy3t1 + 1 hy3t1 + et . When we estimate this model, we still obtain = .09 with t = 2.25 and the estimate of the coecient on the lagged dierence is not signicantly dierent than zero. So we still fail to reject the null of a unit root at the 10% signicance level. We could continue to specify more and more lagged dierences to ensure a dynamically complete model, and carry out the same test to see if we reject the null of unit root. 2.1.3 Trend, no lags

We suppose that there is a trend in {hy3t }, in which case we write, hy3t = + t + hy3t1 + et . The DF test uses more strict critical values when a trend is included. When we estimate this model, we obtain = .15 and t = 3.07. Using the DF critical values for a linear trends, we cannot reject the null of a unit root at the 10% signicance level. The coecient on the time trend cannot be evaluated using the usual t-distribution for the t-statistic (see p. 645). We can use the same tests for a unit root in {hy6t }. In those tests, we actually reject the null of a unit root, but for the sake of example, we will just assume that there is a unit root (this is what Wooldridge does).

2.2
2.2.1

Test for Cointegration

Estimate cointegration factor

We want to study the equilibrium relationship between {hy6t } and {hy3t }. We can write this relationship as hy6t = + hy3t1 + ut . Here, the is understood as the cointegrating factor. 2

If we have theory that tells us what the cointegrating factor should be, then we can just use that to create a new variable, and then use the usual DF test to see if the cointegration hypothesis holds. For example, perhaps theory leads us to believe that = 1. In that case, we simply dene a new variable, dift = hy6t hy3t1 . We check for unit root in dift . The regression results given = 1.03 and t = 11.26, in which case we reject the null of a unit root. If the cointegration factor is unknown, we need to estimate it. We cannot simply estimate hy6t = + hy3t1 + ut because it will not yield appropriate test statistics for (see pp. 649-651). A better choice is a form of the leads lags estimator: hy6t = + hy3t1 + 0 hy3t + 1 hy3t1 + 2 hy3t2 + et . Running this regression, we obtain = 1.03 with standard error 0.02. If we want to test the null hypothesis that = 1, the relevant t-statistic is 1.031 = 1.5, in which case we do not 0.02 reject the null at the 10% signicance level. In the previous model, we assumed no trends and no serial correlation. If we suspect that trends or serial correlation is present, then we use the standard xes (e.g. including a trend variable or using a serial-correlation robust standard error or an AR(1) correction). 2.2.2 Test for cointegration

We can now take our estimate of the cointegration factor and run the DF test for unit root in the variable, hy6t hy3t1 . Because our estimate of is not signicantly dierent from 1 in this example, the appropriate test is precisely that which we ran above on dift when we simply assumed = 1. Since we rejected the null of the presence of a unit root for {dift }, we can be condent that {dift } is I(0), in which case it can be used along with dierences in regressions of {hy6t } on {hy3t }.

2.3

Specifying and Estimating the ECM

We learned above that {hy3t } has a unit root. We also learned that {hy6t } are {hy3t } conintegrated, in which case {dift } is I(0). The integration of {hy3t } suggests that we should not use hy3t in a regression, but rather only its dierences. We may obtain inconsistent estimates; the spurious regression problem may aict our results. However, the fact that {dift } = hy6t hy3t1 is I(0) means that we can include hy6t1 hy3t2 in regressions on dierences in {hy6t } and {hy3t }. We can thus consistently estimate the following model, hy6t = + 0 hy3t1 + (hy6t1 hy3t2 ) + ut , where we the expectations hypothesis has us assume that ut has zero mean, given all hy3 and hy6 dated at time t 1 and earlier (p. 654). (In other words, out hypothesis that 3

E (hy6t |It1 ) = hy3t1 means that there is no need to include lags with terms that extend earlier than t 1.) The estimate of the error correction coecient, , tells us the estimated rate at which out of equilibrium values of hy3 and hy6 are restored to equilibrium via changes in hy6. When we estimate the model above, we nd that = 0.84 with standard error 0.24.

Other Methods

DeBoef (2001) discusses a one-step ECM method care of Banerjee et al (1993). For this example, the one-step method would have use estimate, hy6t = + 0 hy3t1 + (hy6t1 hy3t2 ) + hy3t2 + ut .
Our estimate of the integrating factor, , is then given by 1 . The estimate of has the same interpretation as in the two-step method. When we run this regression, we obtain = 0.89 and = 0.10, in which case = 1.1. A test of whether this estimate was signicantly dierent from 1 would reject the null of no dierence. The dierence in the estimate of is slight. Thus, the two procedures produce very similar results.

Interpretation

We want to interpret these results in relation to the hypothesis that we were testing. Recall that the hypothesis was that E (hy6t |It1 ) = hy3t1 . In evaluating this hypothesis, we note that our analysis of the cointegration of hy6t and hy3t1 led us not to reject the hypothesis that they are cointegrated by a factor = 1. In addition, the ECM showed that when values of hy6t and hy3t1 moved away from this equilibrium relationship, then the magnitude and signicance of the terms showed that there was a strong tendency for hy6t to change in a manner that would restore the equilibrium.