An Introduction to Macroeconometrics:

VEC and VAR Models

1) VEC and VAR Models
2) Estimating a Vector Error Correction
model
3) Estimating a VAR Model
4) Causality
An Introduction to Macroeconometrics:
VEC and VAR Models

𝑦 𝑦
𝑦𝑡 = β10 + β11 𝑥𝑡 + ℯ𝑡 , ℯ𝑡 ∼ 𝑁 0, 𝜎𝑦2 (1a)

𝑥𝑡 = β20 + β21 𝑦𝑡 + ℯ𝑡𝑥 , ℯ𝑡𝑥 ∼ 𝑁 0, 𝜎𝑥2 (1b)

 An Introduction to Macroeconometrics:
VEC and VAR Models

 Aim → Explore the causal relationship between

pairs of time series variables.
• How to estimate a VEC model when there is
cointegration between I(1) variables.
• How to estimate a VAR model when there is no
cointegration.
• Vector indicates that we are considering a
number of series, 2, 3, or more.
 1) VEC and VAR Models
• In Eq. (2), each variable is a function of its own lag,
and the lag of the other variable in the system.
• Together the equations constitute a system known as
a vector autoregressive (VAR)
• VAR is a general framework to describe the
dynamic interrelationship between stationary
variables.
VAR(1) since the max lag is of order 1.
• If y and x are stationary I(0) variables, eq. (2)
𝑦
𝑦𝑡 = β10 + β11 𝑦𝑡−1 + β12 𝑥𝑡−1 + y𝑡
(2)
𝑥𝑡 = β20 + β21 𝑦𝑡−1 + β22 𝑥𝑡−1 + y𝑡𝑥
 1) VEC and VAR Models
 If y and x are nonstationary I(1) and not
cointegrated, examine the interrelation using
VAR framework in first differences Eq. (3).

∆𝑦
∆𝑦𝑡 = β11 ∆𝑦𝑡−1 + β12 ∆𝑥𝑡−1 + y𝑡
(3)
∆𝑥𝑡 = β21 ∆𝑦𝑡−1 + β22 ∆𝑥𝑡−1 + y𝑡∆𝑥

 SR relationship because of first difference.

 No information about the LR behavior is
available.
1) VEC and VAR Models

 If y and x are I(1) and cointegrated, modify

the system of equations to allow for the
cointegrating relationship between them.
 Do this for 2 reasons:
As economists, we like to retain and use
valuable information about the cointegrating
relationship.
As econometricians, we like to ensure that we
use the best technique that take into account the
properties of the time- series data.
 1) VEC and VAR Models
 y and x are I(1) and cointegrated, so that
cointegrating relation (yt and xt are cointegrated –
LR relationship between yt and xt):

𝑦𝑡 = β0 + β1 𝑥𝑡 + 𝑒𝑡 (4)

 Eq. (4) → normalize on y.

 Whether normalize on y or x is often determined from
economic theory.
 There can be at most (not more than) one
fundamental relationship between the two variables.
 1) VEC and VAR Models
 The VEC model is a special form of the VAR for
I(1) variables that are cointegrated. The VEC model
is:
𝑦
∆𝑦𝑡 = 𝛼10 + 𝛼11 𝑦𝑡−1 − β0 − β1 𝑥𝑡−1 + y𝑡
(5a)
∆𝑥𝑡 = 𝛼20 + 𝛼21 𝑦𝑡−1 − β0 − β1 𝑥𝑡−1 + y𝑡𝑥

 Coefficient α11, α21 are error correction coefficients,

because show how much Δyt and Δxt respond to the
cointegrating error yt-1 – β0 – β1xt-1 = et-1
 If et-1 is nonzero, model is out of equilibrium.
 1) VEC and VAR Models
𝑦
∆𝑦𝑡 = 𝛼10 + 𝛼11 𝑦𝑡−1 − β0 − β1 𝑥𝑡−1 + y𝑡
(5a)
∆𝑥𝑡 = 𝛼20 + 𝛼21 𝑦𝑡−1 − β0 − β1 𝑥𝑡−1 + y𝑡𝑥
 The adjustment coefficients in α11 and α21 multiplied by the errors
induce adjustment.
 α11, for example, determines ∆yt, so that the y’s move in the
correct direction in order to bring the system back to
’equilibrium’.
 The adjustment of y in t to et−1, the deviation from the long run in
 (t − 1), is
 ∆yt = (− 0.5)et−1 and yt = ∆yt + yt−1

 If et−1 > 0, the error is positive, i.e. yt-1 is too large, then the
change in y (∆yt), is negative. y decreases to guarantee
convergence back to the long run path.
 1) VEC and VAR Models
Numerical example:

∆yt = (− 0.5)et−1 and yt = ∆yt + yt−1

∆xt = (0.5)et−1 and xt = ∆xt + xt−1

 y => -1 = -0.5 (2) 2 = -1 + 3

 x => 1 = 0.5 (2) 2=1+1
 1) VEC and VAR Models
 The idea that the error leads to a correction comes about
because of the conditions put on α11 and α21 to ensure
stability, namely (-1 < α11 ≤ 0) and (0 ≤ α21 < 1).
-
yt – yt-1 = α10 + α11(et-1) + vt

Above Equilibrium +
[yt-1 > (β0 + β1xt-1)]

 -tive α11 → -tive α11(et-1) → -tive yt – yt-1 (ensures Δy falls)

to restore equilibrium (thereby correcting the error).
 If yt-1 is above equilibrium, it will start falling in the next
period (yt) to correct the equilibrium error (hence the name
ECM)
 1) VEC and VAR Models
 α11 is the feedback effect, or adjustment effect – shows
how much of the disequilibrium is being corrected.
 If α11 = -1, 100% of the adjustment takes place
within the period – error correction is made every
period - full adjustment - perfect adjustment – fast
convergence to the equilibrium relationship.
 If α11 = -0.5, 50% of the adjustment takes place each
period.
 If α11 = 0, no adjustment – no convergence
 Having the error correction coefficients less than 1 in
absolute value ensures that the system is not
explosive.
 1) VEC and VAR Models
+
xt – xt-1 = α20 + α21(et-1) + vt

Below Equilibrium +
[xt-1 < (β0 + β1xt-1)]

 +tive α21 → +tive α21(et-1) → +tive xt – xt-1

(ensures Δx increases) to restore equilibrium
(correcting the error).
 If xt-1 is below equilibrium, it will start increasing
in the next period (xt) to correct the equilibrium
error (hence the name ECM)
 1) VEC and VAR Models
 2 nonstationary cointegrated (related) variables,
consumption (yt) and income (xt).
 Δxt (↑) → Δy (↑), but it take a while to Δy. VEC
model examine how much Δy (cointegrating part →
yt = β0 + β1xt + et) and speed of the change (error
correction part → Δyt = α10 + α11(et-1) + vt)
 β1 is called the LR parameter, α11 and is called SR
parameters.
 Allows the use of both LR information and SR
disequilibrium dynamics.
1) VEC and VAR Models
 Advantages
 Measures the correction from disequilibrium
of the previous period.
 Formulated in first differences, hence
eliminate trends and resolve spurious
regression problem.
 If variables are cointegrated, some adjustment
process will prevent errors in the LR
relationship to grow larger and larger.
 1) VEC and VAR Models
 The role of the intercept terms. In cointegrating
equation (β0) and VEC (α10 and α20).
 Collect all the intercept terms and rewrite (5b) as (5c).
 Obtain estimates of composite terms (α10 – α11β0) and
(α20 – α21β0).
 Not able to resolve the separate effects of β0, α10, α20.
𝑦
𝑦𝑡 = 𝛼10 + 𝛼11 + 1 𝑦𝑡−1 − 𝛼11 β0 − 𝛼11 β1 𝑥𝑡−1 + v𝑡
(5b)
𝑥𝑡 = 𝛼20 + 𝛼21 𝑦𝑡−1 − 𝛼21 β0 − 𝛼21 β1 − 1 𝑥𝑡−1 + v𝑡𝑥

𝑦
𝑦𝑡 = 𝛼10− 𝛼11 β0 + 𝛼11 + 1 𝑦𝑡−1 −𝛼11 β1 𝑥𝑡−1 + v𝑡 (5c)
𝑥𝑡 = 𝛼20− 𝛼21 β0 + 𝛼21 𝑦𝑡−1 − 𝛼21 β1 − 1 𝑥𝑡−1 + v𝑡𝑥