Introduction to Nonlinear

Econometrics

Dirk Nachbar∗
March 1, 2006

∗ Dirk.Nachbar@dwp.gsi.gov.uk

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 Outline

1. Introduction
2. Methodology
3. Application
4. Conclusion
5. References

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 1. Introduction

Assumptions

Since we all studied economics we touched on basic

econometrics.

Some of you might find this boring.

Rationale

As government economists we often make predictions

about certain outcomes using some econometric rela-
tionships. These relationship are usually linear. But as
we live in a complex world many variables are not lin-
ear (think of business cycles). Since there is a large
literature on nonlinear models which can be scary for
most of us, I restrict myself here to some simple non-
linear models, namely Threshold Autoregressive Models
(TAR).

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 2. Methodology

We all know autoregressive models (AR) in which past

values predict future values:
p
X
yt = φ 0 + φi yt−i + ²t, (1)
i=1

where E[²t ] = 0, E[²2t ] = σ 2 and E[²t ²s ] = 0 ∀s 6= t.

If absolute values of the coefficients are above 1 then

we have a random walk. We can integrate the series.

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Self-exciting TAR (SETAR)

½
φ0,1 + φ1,1 yt−1 + ²t if yt−1 ≤ c,
yt = (2)
φ0,2 + φ1,2 yt−1 + ²t if yt−1 > c,

This can also be written as

yt = (φ0,1 + φ1,1yt−1 )(1 − I[yt−1 > c]) (3)
+(φ0,2 + φ1,2 yt−1 )I[yt−1 ≤ c] + ²t (4)

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Logistic STAR
yt = (φ0,1 + φ1,1 yt−1 )(1 − G(yt−1;γ,c )) (5)
+(φ0,2 + φ1,2yt−1 )G(yt−1 ; γ, c) + ²t, (6)
where G(yt−1 ; γ, c) = (1 + exp(−γ[yt−1 − c]))−1 .

When γ → 0 then G becomes a constant (0.5).

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Estimation

We need to estimate the coefficients ρ and c. We can

do this by sequential conditional least squares.

Rewrite the SETAR as:

yt = φ1 xI[yt−1 ≤ c] + φ2 xI[yt−1 > c] + ²t (7)
where x = (1, yt−1, xt−2 , .., yt−p ). Then
à n !−1 à n !
X X
φ̂ = x(c)x(c)0 x(c)yt , (8)
t=1 t=1

where x(c) = (x0 I[yt−1 ≤ c], x0 I[yt−1 > c])0 .

This is similar to the standard OLS estimator: (XX 0 )−1 (XY ).

The threshold can be obtained:

ĉ = arg min σ̂ 2 (9)
c∈C

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 3. Application

I generated a SETAR(2) model in Excel:

a0 a1 a2 b0 b1 b2 C
Real 0.5 0.8 -0.5 0 0.8 -0.2 0
Est. 0.66 0.67 -0.46 -0.02 0.78 -0.23 -0.01

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 4. Conclusion

Nonlinear is fun!

Relevant in Policy??

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 5. Reference

Franses and van Dijk. Non-linear time series models in

empirical finance. Cambridge UP. 2000

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