Granger Causality

Granger Causality VAR

Granger Causality

(Time Series Econometrics, J. Hamilton, p302)

If past X contains useful information (in addition to the information in past Y) to predict future Y, we say X granger causes Y. Note that Granger-causality may or may not indicate causal effect of x on y (could you think of some examples?)

Linear Bivariate Granger Causality Tests

Z fails to Granger-causes y if MSE[E(xt|It-1)] = MSE[E(xt|Jt-1)]
Here It-1 contains past information on Y and Z while Jt-1 contains past information on Y only.

Grangers test
Regression: xt=c+xt-1+yt-1+ut Test H0: =0

Sims test
Regression: yt=c+hyt-1+bxt-1+dxt+1+vt Test H0: d=0

The Stock Price-Volume Relation (Hiemstra and Jones, 1994)

Whether knowing past stock price movements improves short-run forecasts of movements in trading volume (vice versa)?
People may use changes in equity prices or trade volume to infer new information in the equity market. Hence, changes in past equity prices or trade volume may affect future prices and volume. This implies bi-directional pricevolume relationship.

Data
Daily Dow Jones tock returns and percentage changes in New york Stock Exchange trading volume. Be careful of structural change in the model
Due to a structural break at the end of 1946, the causality tests are conducted over the 1915 to 1946 and 1947 to 1990 periods.

What if the time series are not stationary?

A typical way to transform a nonstationary time series into stationary ones is to take differences
A series xt is integrated of order d (we call it I(d) process) if the series becomes stationary after differencing d times.

Traditional (Linear) Granger Causality

The trade volume series appears nonstationary, suggesting that differencing is needed to make the volume series stationary. The traditional linear Granger test detects unidirectional Granger causality from stock prices to trading volume.

Improved Granger-Causality Test

Traditional Granger causality tests might overlook a significant nonlinear relation between stock returns and trading volume.

Nonlinear Granger Causality Test

Why nonlinear? When the assumption of representativeagent in traditional trading model is relaxed (i.e. heterogeneous agents are allowed), nonlinear dynamics become typical in the price-volume relation. An example: yt=yt-L*xt-M+t Findings: Significant nonlinear bidirectional Granger causality between stock prices and trading volume in both sample periods.

Vector Autoregressive (VAR) Model

VAR models simultaneously estimates the interrelationship between more than one endogenous variables.

Yt=AYt-1+Ut
Y is a vector containing different variables. A is a coefficient Matrix. U is the corresponding vector of residuals, which have nonzero cross correlations.

An Example
Y=(y z) A=( ; )
Or

yt=+yt-1+zt-1+ut zt=+yt-1+zt-1+vt

Impulse Response
The dynamics of a VAR model can be visualized by impulse response diagrams.
Given a stable VAR model (like stationarity) Impose a one-time shock to the system (the shock can be on any endogenous variables) Trace out the deviation of all endogenous variables from their equilibrium values in the following time periods.

Why VAR?
VARs have been used primarily in macroeconomics to capture the relationship between important economic variables.
VAR model provides a natural framework to test the Granger Causality.

Estimating the VAR Model

Yt=AYt-1+Ut Under certain conditions on the structure of A and the property of U, the multi-equation VAR model can be solved for best estimates of A. What is structural VAR?
If the structure of A is chosen based on economic theory, then we call this VAR model a structural VAR.

The Dynamic Effects of Government Spending and Taxes on Output (Blanchard and Perotti, 2002)

Theory: Why and how should government spending and taxes affect aggregate outputs?
Keynesian: A positive effect of government spending on private consumption Neoclassical: Both increases in taxes and increases in government spending have a negative effect on private investment

Data
Quarterly National Income and Product Accounts Quarterly Treasury Bulletin. Whole sample is 1947:1 to 1997:4 Due to structural breaks before 1960, only the sample after 1960:1 is selected.

The Model
Y=(T,G,X) is a vector containing the logarithms of quarterly taxes, spending, and GDP.

The Model (continued)

U=(et,eg,ex) is a vector of residuals. They represent unexpected movements in taxes, spending, and GDP. t=a1x+a2eg+et g=b1x+b2et+eg x=c1t+c2g+ex Where et, eg, ex are the mutually uncorrelated structural shocks that we want to recover We are interested in the coefficients c1 and c2.

Identification Strategy
Determine a1 and b1
The two coefficients capture the effects of economic activity on taxes and spending under existing fiscal policy rules No automatic feedback from economic activity to government expenditure is identified, so b1=0. Independent estimates suggest a1is around 2.

Construct residuals t=t-a1x and g=g, use them as instruments for the third equation, estimating c1 and c2. Then we make (non-structural) assumption on a2 and b2 to estimate them.

Main Findings
Effect on Aggregate Output
Positive government spending shocks have a positive effect on output Positive tax shocks have a negative effect on output