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'we must remember that the price of capital goods varies not
only by reason of past changes but also by reason of
expected changes either in gross income or in rates of
depreciation and insurance' Walras (1954)p310.
( t -1 x - x ) = ( xt -1 -t - 2 x )
e
t t -2
e
t -1
e
t -1 0 < <1
By simply rearranging this we can get,
( t -1 x ) = xt -1 + (1 - )t - 2 x
e
t
e
t -1
and
( t -1 x ) = xt -1 + (1 - ) xt -2 + (1 - ) xt -3 . . .
e 2
t
expectation
expectation
X t = Gt + Z t
And
Z t = X t + t
Now under one regime where G is simply held fixed a
reasonable expectations rule to form expectations about the
future value of X would simply be,
e
)= G t+1
(t X
1-
t+1
e
(t X t +1 )= X t
Suppose the government changed its policy rule and decided
that from now on G would grow at 10% per period. The first
equation would still be a valid approach, but the second is no
longer appropriate as the growth in G would now imply that
e
(t X t+1 ) = 1.1X t
So the model which uses the structure of the system remains
unchanged when the policy rule changes.
RE implies
E( t+1 | t ) = E( t+1 | t ) = 0
E( | ) =
2
t +1
2
if
xt+1 = xt + et
so xt+k = xt + et+1 + ...+ et+k
k
and so
e
xt+1 -t x = et+1
t +1
e
xt+2 -t xt+2 = et+1 + et+2
The one step ahead forecast is independent white noise but
further ahead forecasts are correlated, although all are
independent of the information set.
e
( t+1 x - x
t+ j t
e
t+ j ) = f( t+1 - t )
Direct tests of RE
xt+1 = 0
+ ( e
1 t xt +1
) + 2 t + t
where H 0 : 0 = 0 = 2 , 1 = 1
x t +k = 0 + 1 ( t x ) + 2 t + t
e
t +k
where H 0 : 0 = 0 = 2 , 1 = 1
but t = 0 et + 1 et -1 + ... k et - k
This presents problems of inference and much attention has
been devoted to constructing correct tests for this case.
Much financial data often contains this problem especially eg
monthly data on three month rates of return.
Y t = 1( t X )+ 2 ( t X
e e
t +1 t +2 ) + ut
under RE we have,
xt+i =t x + t+i
e
t+i
and so
Now the Xs are correlated with the error term and there is an
MA(2) error process. This is the general problem created by
RE estimation.
We could do FIML estimation if we had a model for X, but this
is expensive and often not robust. a much more common way
of dealing with these problems is the Errors in Variable (EVM)
approach.
Y t = 1( t X ) + 2 ( X t,2 ) + u t
e
t +1,1
Y t = 1( X t+1,1 ) + 2 ( X t,2 ) + ut
This is all an instrumental variable estimator is except that
the IV estimator does the process in one go. The two will give
identical estimates for the parameters but different standard
errors and `t' statistics as the IV estimator uses
ut = Y t - 1( X t+1,1 ) - 2 ( X t,2 )
To calculate the SE while the 2 step procedure uses the
instrumenting variable
Extrapolative predictors
( t X t+2 ) = (L)[(L) xt ]
e
Y t = 1( t X )+ 2 ( t X
e e
t +1 t +2 ) + ut
under RE we have,
xt+i =t x + t+i
e
t+i
and so
et = Y t - 1( X t+1 ) + 2 ( X t+2 )
Now the corrected covariance in the presence of an MA(2)
error process will be
1 1 0 0 ... 0
1 1 1 0 ... 0
E(ee) = 2 0 1 1 1 ... 0 = 2
. . .
0 0 ...0 1 1
where
T
ei /T
=2 2
i=1
T
1=[ ei ei -1 ]/T
2
i= 2
and
VAR( ) = (X X ) (X X)(X X )
2 -1 -1
Newey West
i=1
T
j=[ w(j,m)e e
2
i i- j ]/T j=1...m
i= j+1
Y t = 1 ( X t+1 ) ut 1 ut -1
Y t (1 - 1 L ) = (1 - 1 L ) [ 1( X t+1 ) + 2 ( X t+2 )] + ut
-1 -1
Yt (1 +1L )
-1 -1
= (1 + 1 L ) 1 X t+1 2 X t+2
-1 -1
[ ( ) + ( )] + *
ut
The Cumbey (1983) 2-step, 2-Stage LS
If y = x + q
E(q q) = plim( T (xq))NE0
2 -1
2 = [xV(V V ) V x ] [xV(V V ) V y]
-1 -1 -1
var( 2 ) = [xV(V V ) V x )
2 -1 -1
Cross Equation Restrictions
Y t = 1 ( (L) X t -1 ) + u t + 1 vt
X t+1 = (L) X t -1 + vt
Testing this restriction then entails a joint test of the model
and the RE assumption.
The Importance of Expectations
S( x1 , x2 , 1 , 2 )
x1 = X 1( 1 , 2 )
x2 = X 2 ( x1 , 1 , 2 )
Now if we derive the first order condition for policy in period
2 from the standpoint of a policy maker in period 1 we get,
S x2 S S x1
. + + . =0
x2 2 2 x1 2
Ef( yt ) f(E( yt ))
So the expected value of the sterling dollar exchange rate does
not equal 1/ the expected value of the dollar sterling rate.
E ( / $) 1 / E ($ / )
One significant
result
This table Test using lagged cross rates from all markets
More significant
results
But now shorten the period to exclude the 1973 oil price crises
Less significant
number of results
Testing using more cross rates
Some increase
in significance
Now consider data from the 1920s
Lots of significant
results