FOOTNOTE: THE COCHRANE-ORCUTT ITERATIVE PROCESS

yt    xt  ut ut  ut 1   t
yt 1    xt 1  ut 1
yt  yt 1   (1   )  xt  xt 1  ut  ut 1
yt   (1   )  yt 1  xt  xt 1   t

We saw in the previous sequence that AR(1) autocorrelation could be eliminated by a simple
manipulation of the model. The regression model is nonlinear in parameters, but that now
presents no problem for fitting it.
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 FOOTNOTE: THE COCHRANE-ORCUTT ITERATIVE PROCESS

yt    xt  ut ut  ut 1   t
yt 1    xt 1  ut 1
yt  yt 1   (1   )  xt  xt 1  ut  ut 1
yt   (1   )  yt 1  xt  xt 1   t

However, in the early days of computing, nonlinear estimation was not so simple and it was
avoided whenever possible. The Cochrane-Orcutt iterative procedure was an ingenious
method of using linear regression analysis to fit this nonlinear model.
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 FOOTNOTE: THE COCHRANE-ORCUTT ITERATIVE PROCESS

yt    xt  ut ut  ut 1   t
yt 1    xt 1  ut 1
yt  yt 1   (1   )  xt  xt 1  ut  ut 1
yt   (1   )  yt 1  xt  xt 1   t

It is of no practical interest now, but you may see references to it occasionally. This
sequence explains how it worked.

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 FOOTNOTE: THE COCHRANE-ORCUTT ITERATIVE PROCESS

yt    xt  ut ut  ut 1   t
yt 1    xt 1  ut 1
yt  yt 1   (1   )  xt  xt 1  ut  ut 1
~y      x
~  ~y  y  y
t t t t t t 1
~  x  x
x t t t 1
    (1   )

We return to line 3 and note that the model can be rewritten as shown with appropriate
definitions. We now have a simple regression model free from autocorrelation.

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 FOOTNOTE: THE COCHRANE-ORCUTT ITERATIVE PROCESS

yt    xt  ut ut  ut 1   t
yt 1    xt 1  ut 1
yt  yt 1   (1   )  xt  xt 1  ut  ut 1
~y      x
~  ~y  y  y
t t t t t t 1
~  x  x
x t t t 1
    (1   )

However, to construct the artificial variables y~t and x~t , we need an estimate of . We obtain
one using the residuals. If the disturbance term is generated by an AR(1) process, et will be
related to et-1 by a similar process.
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 FOOTNOTE: THE COCHRANE-ORCUTT ITERATIVE PROCESS

yt    xt  ut ut  ut 1   t
yt 1    xt 1  ut 1
yt  yt 1   (1   )  xt  xt 1  ut  ut 1
~y      x
~  ~y  y  y
t t t t t t 1
~  x  x
x t t t 1
    (1   )
1. Regress yt on xt using OLS
2. Calculate et = yt - a - bxt and regress et on et-1 to obtain
an estimate of .
3. Calculate yt and xt and regress yt on xt to obtain
revised estimates a and b. Return to 2. and
continue until convergence.
The first step is to regress the original model, using OLS.

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 FOOTNOTE: THE COCHRANE-ORCUTT ITERATIVE PROCESS

yt    xt  ut ut  ut 1   t
yt 1    xt 1  ut 1
yt  yt 1   (1   )  xt  xt 1  ut  ut 1
~y      x
~  ~y  y  y
t t t t t t 1
~  x  x
x t t t 1
    (1   )
1. Regress yt on xt using OLS
2. Calculate et = yt - a - bxt and regress et on et-1 to
obtain an estimate of .
3. Calculate yt and xt and regress yt on xt to obtain
revised estimates a and b. Return to 2. and
continue until convergence.
We save the residuals and regress et on et-1. The slope coefficient will be an estimate of .

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 FOOTNOTE: THE COCHRANE-ORCUTT ITERATIVE PROCESS

yt    xt  ut ut  ut 1   t
yt 1    xt 1  ut 1
yt  yt 1   (1   )  xt  xt 1  ut  ut 1
~y      x
~  ~y  y  y
t t t t t t 1
~  x  x
x t t t 1
    (1   )
1. Regress yt on xt using OLS
2. Calculate et = yt - a - bxt and regress et on et-1 to
obtain an estimate of .
3. Calculate ~yt and x~t and regress ~
yt on x~t to obtain
revised estimates a and b. Return to 2. and
continue until convergence.
We then calculate the artificial variables y~t and x~t and regress y~t on x~t. The slope coefficient
will be an estimate of  and an estimate of  can be derived from the intercept.

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 FOOTNOTE: THE COCHRANE-ORCUTT ITERATIVE PROCESS

yt    xt  ut ut  ut 1   t
yt 1    xt 1  ut 1
yt  yt 1   (1   )  xt  xt 1  ut  ut 1
~y      x
~  ~y  y  y
t t t t t t 1
~  x  x
x t t t 1
    (1   )
1. Regress yt on xt using OLS
2. Calculate et = yt - a - bxt and regress et on et-1 to
obtain an estimate of .
3. Calculate ~yt and x~t and regress ~
yt on x~t to obtain
revised estimates a and b. Return to 2. and
continue until convergence.
We return to Step 2, recalculate the residuals, and regress et on et-1 again to obtain a better
estimate of .

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 FOOTNOTE: THE COCHRANE-ORCUTT ITERATIVE PROCESS

yt    xt  ut ut  ut 1   t
yt 1    xt 1  ut 1
yt  yt 1   (1   )  xt  xt 1  ut  ut 1
~y      x
~  ~y  y  y
t t t t t t 1
~  x  x
x t t t 1
    (1   )
1. Regress yt on xt using OLS
2. Calculate et = yt - a - bxt and regress et on et-1 to
obtain an estimate of .
3. Calculate ~yt and x~t and regress ~
yt on x~t to obtain
revised estimates a and b. Return to 2. and
continue until convergence.
We then return to Step 3 and keep alternating between Step 2 and Step 3 until convergence
is obtained. Thus the nonlinear model could be fitted using linear regression analysis.

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