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ßujarati.

ßasic
Ecoooæetrics, Fourth
Editioo
ModeIs
22. Iiæe 8eries
Ecoooæetrics. Forecastiog Cuauories, Z00+
856 PART FOUR: SÌMULTANEOUS-EQUATÌON MODELS
20
PIIIIµ Hans Iranses, Tinc Scrics Modc/s jor Eusincss and Icononic Iorccas/in¸, Can-
LrIdge UnIversIIy Press, Nev York, 1998, µ. 155.
21
R. LngIe, "AuIoregressIve CondIIIonaI HeIeroscedasIIcIIy vIII LsIInaIes oI IIe VarIance
oI UnIIed KIngdon InlaIIon,¨ Icononc/rica, voI. 50. no. 1, 1982, µµ. 987-1007. See aIso A. Bera
and M. HIggIns, "ARCH ModeIs: ProµerIIes, LsIInaIIon and TesIIng,¨ 1ourna/ oj Icononic Sur-
vcys, voI. 7, 1993, µµ. 305-366.
22.10 MEASURING VOLATILITY IN FINANCIAL TIME SERIES:
THE ARCH AND GARCH MODELS
As noIed In IIe InIroducIIon Io IIIs cIaµIer, hnancIaI IIne serIes, sucI as
sIock µrIces, excIange raIes, InlaIIon raIes, eIc. oIIen exIILII IIe µIenone-
non oI volutility clustering, IIaI Is, µerIods In vIIcI IIeIr µrIces sIov vIde
svIngs Ior an exIended IIne µerIod IoIIoved Ly µerIods In vIIcI IIere Is
reIaIIve caIn. As PIIIIµ Iranses noIes:
SInce sucI [hnancIaI IIne serIes| daIa relecI IIe resuII oI IradIng anong Luyers
and seIIers aI, Ior exanµIe, sIock narkeIs, varIous sources oI nevs and oIIer ex-
ogenous econonIc evenIs nay Iave an InµacI on IIe IIne serIes µaIIern oI asseI
µrIces. GIven IIaI nevs can Iead Io varIous InIerµreIaIIons, and aIso gIven IIaI
sµecIhc econonIc evenIs IIke an oII crIsIs can IasI Ior sone IIne, ve oIIen oLserve
IIaI Iarge µosIIIve and Iarge negaIIve oLservaIIons In hnancIaI IIne serIes Iend Io
aµµear In cIusIers.
20
KnovIedge oI voIaIIIIIy Is oI crucIaI InµorIance In nany areas. Ior ex-
anµIe, consIderaLIe nacroecononeIrIc vork Ias Leen done In sIudyIng IIe
varIaLIIIIy oI InlaIIon over IIne. Ior sone decIsIon nakers, InlaIIon In II-
seII nay noI Le Lad, LuI IIs varIaLIIIIy Is Lad Lecause II nakes hnancIaI
µIannIng dIIhcuII.
TIe sane Is Irue oI InµorIers, exµorIers, and Iraders In IoreIgn excIange
narkeIs, Ior varIaLIIIIy In IIe excIange raIes neans Iuge Iosses or µrohIs.
InvesIors In IIe sIock narkeI are oLvIousIy InIeresIed In IIe voIaIIIIIy oI
sIock µrIces, Ior IIgI voIaIIIIIy couId nean Iuge Iosses or gaIns and Ience
greaIer uncerIaInIy. In voIaIIIe narkeIs II Is dIIhcuII Ior conµanIes Io raIse
caµIIaI In IIe caµIIaI narkeIs.
Hov do ve nodeI hnancIaI IIne serIes IIaI nay exµerIence sucI voIaIII-
IIy? Ior exanµIe, Iov do ve nodeI IInes serIes oI sIock µrIces, excIange
raIes, InlaIIon, eIc.? A cIaracIerIsIIc oI nosI oI IIese hnancIaI IIne serIes Is
IIaI In IIeIr /cvc/ jorn IIey are randon vaIks, IIaI Is, IIey are nonsIaIIon-
ary. On IIe oIIer Iand, In IIe hrsI dIIIerence Iorn, IIey are generaIIy sIa-
IIonary, as ve sav In IIe case oI GDP serIes In IIe µrevIous cIaµIer even
IIougI GDP Is noI sIrIcIIy a hnancIaI IIne serIes.
TIereIore, InsIead oI nodeIIng IIe IeveIs oI hnancIaI IIne serIes, vIy noI
nodeI IIeIr hrsI dIIIerences? BuI IIese hrsI dIIIerences oIIen exIILII vIde
svIngs, or volutility, suggesIIng IIaI IIe varIance oI hnancIaI IIne serIes
varIes over IIne. Hov can ve nodeI sucI "varyIng varIance¨? TIIs Is vIere
IIe so-caIIed uutoregressive conditionul heteroscedusticity (ARCH)
nodeI orIgInaIIy deveIoµed Ly LngIe cones In Iandy.
21
As IIe nane suggesIs, IeIeroscedasIIcIIy, or unequaI varIance, nay Iave
an auIoregressIve sIrucIure In IIaI IeIeroscedasIIcIIy oLserved over dIIIer-
ßujarati. ßasic
Ecoooæetrics, Fourth
Editioo
ModeIs
22. Iiæe 8eries
Ecoooæetrics. Forecastiog Cuauories, Z00+
CHAPTER TWENTY-TWO: TÌME SERÌES ECONOMETRÌCS: FORECASTÌNG 857
enI µerIods nay Le auIocorreIaIed. To see vIaI aII IIIs neans, IeI us con-
sIder a concreIe exanµIe.
U.S./U.K. EXCHANGE RATE: AN EXAMPLE
Figure 22.6 gives logs of the monthly U.S./U.K. exchange rate (dollars per pound) for the
period 1973 to 1995, for a total of 276 monthly observations. As you can see from this fgure,
there are considerable ups and downs in the exchange rate over the sample period. To
see this more vividly, in Figure 22.7 we plot the changes in the logs of the exchange rate; note
that changes in the log of a variable denote relative changes, which, if multiplied by 100,
give percentage changes. As you can observe, the relative changes in the U.S./U.K. ex-
change rate show periods of wide swings for some time period and periods of rather moder-
ate swings in other time periods, thus exemplifying the phenomenon of volatility clustering.
Now the practical question is: How do we statistically measure volatility? Let us illustrate
this with our exchange rate example.
Let Y
t
 U.S./U.K. exchange rate
Y
t
*  log of Y
t
dY
t
*  Y
t
*  Y
t
*
1
 relative change in the exchange rate
d

Y
t
*  mean of dY
t
*
X
t
 dY
t
*  d

Y
t
*
Thus, X
t
is the mean-adjusted relative change in the exchange rate. Now we can use X
2
t
as
a measure of volatility. Being a squared quantity, its value will be high in periods when there
are big changes in the prices of fnancial assets and its value will be comparatively small
when there are modest changes in the prices of fnancial assets.
22
74
0.0
76 78 80 82 84 86 88 90 92 94
0.2
0.4
0.6
0.8
1.0
Year
FIGURE 22.6 Log of U.S./U.K. exchange rate, 1973-1995 (monthly)
22
You nIgII vonder vIy ve do noI use IIe varIance oI X
/
 X
2
/
n as a neasure oI voIaIII-
IIy. TIIs Is Lecause ve vanI Io Iake InIo accounI cIangIng voIaIIIIIy oI asseI µrIces over IIne. II
ve use IIe varIance oI X
/
, II vIII onIy Le a sIngIe vaIue Ior a gIven daIa seI.
(Continued)
ßujarati. ßasic
Ecoooæetrics, Fourth
Editioo
ModeIs
22. Iiæe 8eries
Ecoooæetrics. Forecastiog Cuauories, Z00+
858 PART FOUR: SÌMULTANEOUS-EQUATÌON MODELS
Accepting X
2
t
as a measure of volatility, how do we know if it changes over time? Sup-
pose we consider the following AR(1), or ARÌMA (1, 0, 0), model:
X
2
t

0

1
X
2
t 1
 u
t (22.10.1)
This model postulates that volatility in the current period is related to its value in the previous
period plus a white noise error term. Ìf
2
is positive, it suggests that if volatility was high in
the previous period, it will continue to be high in the current period, indicating volatility clus-
tering. Ìf
1
is zero, then there is no volatility clustering. The statistical signifcance of the es-
timated
2
can be judged by the usual t test.
There is nothing to prevent us from considering an AR(p) model of volatility such that
X
2
t

0

1
X
2
t 1

2
X
2
t 2
    
p
X
2
t p
 u
t (22.10.2)
This model suggests that volatility in the current period is related to volatility in the past p pe-
riods, the value of p being an empirical question. This empirical question can be resolved by
one or more of the model selection criteria that we discussed in Chapter 13 (e.g., the Akaike
information measure). We can test the signifcance of any individual coeffcient by the t test
and the collective signifcance of two or more coeffcients by the usual F test.
Model (22.10.1) is an example of an ARCH(1) model and (22.10.2) is called an ARCH()
model, where p represents the number of autoregressive terms in the model.
Before proceeding further, let us illustrate the ARCH model with the U.S./U.K. exchange
rate data. The results of the ARCH(1) model were as follows.
X
2
t
 0.0006  0.1694X
2
t 1
t  (6.7831) (2.8355) R
2
 0.0287 d  1.9972
(22.10.3)
where X
2
t
is as defned before.
U.S./U.K. EXCHANGE RATE: AN EXAMPLE (Continued)
(Continued)
74
-0.12
76 78 80 82 84 86 88 90 92 94
-0.08
-0.04
0.00
0.04
0.08
0.12
Year
FIGURE 22.7 Change in the log of U.S./U.K. exchange rate.
ßujarati. ßasic
Ecoooæetrics, Fourth
Editioo
ModeIs
22. Iiæe 8eries
Ecoooæetrics. Forecastiog Cuauories, Z00+
CHAPTER TWENTY-TWO: TÌME SERÌES ECONOMETRÌCS: FORECASTÌNG 859
Since the coeffcient of the lagged term is highly signifcant (p value of about 0.005), it
seems volatility clustering is present in the present instance. We tried higher-order ARCH
models, but only the AR(1) model turned out to be signifcant.
How would we test for the ARCH effect in a regression model in general that is based on
time series data? To be more specifc, let us consider the k-variable linear regression model:
Y
t

1

2
X
2t
    
k
X
kt
 u
t
(22.10.4)
and assume that conditional on the information available at time (t  1), the disturbance term
is distributed as
u
t
N 0,
0

1
u
2
t 1
(22.10.5)
that is, u
t
is normally distributed with zero mean and
var (u
t
) 
0

1
u
2
t 1
(22.10.6)
that is, the variance of u
t follows an ARCH(1) process.
The normality of u
t
is not new to us. What is new is that the variance of u at time t is de-
pendent on the squared disturbance at time (t  1), thus giving the appearance of serial cor-
relation.
23
Of course, the error variance may depend not only on one lagged term of the
squared error term but also on several lagged squared terms as follows:
var (u
t
) 
2
t

0

1
u
2
t 1

2
u
2
t 2
    
p
u
2
t p
(22.10.7)
Ìf there is no autocorrelation in the error variance, we have
H
0
:
1

2
    
p
 0 (22.10.8)
in which case var(u
t
) 
0
, and we do not have the ARCH effect.
Since we do not directly observe
2
t
, Engle has shown that running the following regres-
sion can easily test the preceding null hypothesis:
u
2
t 0 1
u
2
t 1 2
u
2
t 2 p
u
2
t p
(22.10.9)
where u
t
, as usual, denote the OLS variance obtained from the original regression model
(22.10.4).
One can test the null hypothesis H
0
by the usual F test, or alternatively, by computing
nR
2
, where R
2
is the coeffcient of determination from the auxiliary regression (22.10.9). Ìt
can be shown that
nR
2
asy
2
p
(22.10.10)
that is, in large samples nR
2
follows the chi-square distribution with df equal to the number
of autoregressive terms in the auxiliary regression.
Before we proceed to illustrate, make sure that you do not confuse autocorrelation of the
error term as discussed in Chapter 12 and the ARCH model. Ìn the ARCH model it is the
(conditional) variance of u
t
that depends on the (squared) previous error terms, thus giving
the impression of autocorrelation.
U.S./U.K. EXCHANGE RATE: AN EXAMPLE (Continued)
23
A IecInIcaI noIe: RenenLer IIaI Ior our cIassIcaI IInear nodeI IIe varIance oI u
/
vas
assuned Io Le
2
, vIIcI In IIe µresenI conIexI Lecones uncondIIIonaI varIance. II
1
 1, IIe
sIaLIIIIy condIIIon, ve can vrIIe
2

0

1
2
 IIaI Is,
2

0
(1 
1
) TIIs sIovs IIaI IIe
uncondIIIonaI varIance oI u does noI deµend on /, LuI does deµend on IIe ARCH µaraneIer
1

ßujarati. ßasic
Ecoooæetrics, Fourth
Editioo
ModeIs
22. Iiæe 8eries
Ecoooæetrics. Forecastiog Cuauories, Z00+
860 PART FOUR: SÌMULTANEOUS-EQUATÌON MODELS
NEW YORK STOCK EXCHANGE PRÌCE CHANGES
As a further illustration of the ARCH effect, Figure 22.8 presents monthly percentage change
in the NYSE (New York Stock Exchange) Ìndex for the period 1952-1995.
24
Ìt is evident from
this graph that the percent price changes in the NYSE Ìndex exhibit considerable volatility.
Notice especially the wide swing around the 1987 crash in stock prices.
To capture the volatility in the stock return seen in the fgure, let us consider a very simple
model:
Y
t

1
 u
t (22.10.11)
where Y
t
 percent change in the NYSE stock index and u
t
 random error term.
Notice that besides the intercept, there is no other explanatory variable in the model.
From the data, we obtained the following OLS regression:
Y
t
 0.00686
t  (3.8835) (22.10.12)
d  1.9215
What does this intercept denote? Ìt is simply the average percent rate of return on the NYSE
index, or the mean value of Y
t
(can you verify this?). Thus over the sample period the aver-
age monthly return on the NYSE index was about 0.0069 percent.
24
TIIs graµI and IIe regressIon resuIIs µresenIed LeIov are Lased on IIe daIa coIIecIed Ly
Gary Kooµ, Ana/ysis oj Icononic Da/a, 1oIn WIIey & Sons, Nev York, 2000 (daIa Iron IIe daIa
dIsk). TIe nonIIIy µercenIage cIange In IIe sIock µrIce Index can Le regarded as a raIe oI re-
Iurn on IIe Index.
(Continued)
FIGURE 22.8
Monthly percent change in the NYSE Price Ìndex, 1952-1995.
55
-0.3
-0.2
-0.1
0.0
0.1
0.2
60 65 70 75 80 85 90 95
Year
ßujarati. ßasic
Ecoooæetrics, Fourth
Editioo
ModeIs
22. Iiæe 8eries
Ecoooæetrics. Forecastiog Cuauories, Z00+
CHAPTER TWENTY-TWO: TÌME SERÌES ECONOMETRÌCS: FORECASTÌNG 861
Now we obtain the residuals from the preceding regression and estimate the ARCH(1)
model, which gave the following results:
u
2
t
 0.00145  0.1167u
2
t 1
t  (8.8929) (2.6934) (22.10.13)
R
2
 0.0136 d  2.0121
where u
t
is the estimated residual from regression (22.10.12).
Since the lagged squared disturbance term is statistically signifcant (p value of about
0.007), it seems the error variances are correlated; that is, there is an ARCH effect. We tried
higher-order ARCH models but only ARCH(1) was statistically signifcant.
What To Do if ARCH Is Present
RecaII IIaI ve Iave dIscussed severaI neIIods oI correcIIng Ior IeI-
eroscedasIIcIIy, vIIcI LasIcaIIy InvoIved aµµIyIng OLS Io IransIorned daIa.
RenenLer IIaI OLS aµµIIed Io IransIorned daIa Is generaIIzed IeasI
squares (GLS). II IIe ARCH eIIecI Is Iound, ve vIII Iave Io use GLS. We vIII
noI µursue IIe IecInIcaI deIaIIs, Ior IIey are Leyond IIe scoµe oI IIIs
Look.
25
IorIunaIeIy, soIIvare µackages sucI as LvIevs, SIazan, MIcrohI,
and Pc-GIve Iave nov user-IrIendIy rouIInes Io esIInaIe sucI nodeIs.
A Word on the Durbin-Watson  and the ARCH Effect
We Iave renInded IIe reader severaI IInes IIaI a sIgnIhcanI d sIaIIsIIc nay
noI aIvays nean IIaI IIere Is sIgnIhcanI auIocorreIaIIon In IIe daIa aI
Iand. Very oIIen a sIgnIhcanI d vaIue Is an IndIcaIIon oI IIe nodeI sµecIh-
caIIon errors IIaI ve dIscussed In CIaµIer 13. Nov ve Iave an addIIIonaI
sµecIhcaIIon error, IIaI due Io IIe ARCH eIIecI. TIereIore, In a IIne serIes
regressIon, II a sIgnIhcanI d vaIue Is oLIaIned, ve sIouId IesI Ior IIe ARCH
eIIecI LeIore acceµIIng IIe d sIaIIsIIc aI IIs Iace vaIue. An exanµIe Is gIven In
exercIse 22.23.
A Note on the GARCH ModeI
SInce IIs "dIscovery¨ In 1982, ARCH nodeIIng Ias Lecone a grovII Indus-
Iry, vIII aII kInds oI varIaIIons on IIe orIgInaI nodeI. One IIaI Ias Lecone
NEW YORK STOCK EXCHANGE PRÌCE CHANGES (Continued)
25
ConsuII RusseII DavIdson and 1anes G. MacKInnon, Is/ina/ion and Injcrcncc in Icono-
nc/rics, OxIord UnIversIIy Press, Nev York, 1993, Sec. 16.4 and WIIIIan H. Greene, Icononc/-
ric Ana/ysis, 4II ed., PrenIIce HaII, LngIevood CIIIIs, N.1., 2000, Sec. 18.5.
ßujarati. ßasic
Ecoooæetrics, Fourth
Editioo
ModeIs
22. Iiæe 8eries
Ecoooæetrics. Forecastiog Cuauories, Z00+
862 PART FOUR: SÌMULTANEOUS-EQUATÌON MODELS
µoµuIar Is IIe generulized uutoregressive conditionul heteroscedusticity
(GARCH) nodeI, orIgInaIIy µroµosed Ly BoIIersIev.
26
TIe sInµIesI GARCH
nodeI Is IIe GARCH(1, 1) nodeI, vIIcI can Le vrIIIen as:
2
/

0

1
u
2
/1

2
2
/1
(22.10.14)
vIIcI says IIaI IIe condIIIonaI varIance oI u aI IIne / deµends noI onIy on
IIe squared error Iern In IIe µrevIous IIne µerIod [as In ARCH(1)| LuI aIso
on IIs condIIIonaI varIance In IIe µrevIous IIne µerIod. TIIs nodeI can Le
generaIIzed Io a GARCH( p, q) nodeI In vIIcI IIere are p Iagged Ierns oI
IIe squared error Iern and q Ierns oI IIe Iagged condIIIonaI varIances.
We vIII noI µursue IIe IecInIcaI deIaIIs oI IIese nodeIs, as IIey are In-
voIved, exceµI Io µoInI ouI IIaI a GARCH(1, 1) nodeI Is equIvaIenI Io an
ARCH(2) nodeI and a GARCH( p, q) nodeI Is equIvaIenI Io an ARCH(p  q)
nodeI.
27
Ior our U.S./U.K. excIange raIe and NYSL sIock reIurn exanµIes, ve
Iave aIready sIaIed IIaI an ARCH(2) nodeI vas noI sIgnIhcanI, suggesIIng
IIaI µerIaµs a GARCH(1, 1) nodeI Is noI aµµroµrIaIe In IIese cases.
22.11 CONCLUDING EXAMPLES
We concIude IIIs cIaµIer Ly consIderIng a Iev addIIIonaI exanµIes IIaI II-
IusIraIe sone oI IIe µoInIs ve Iave nade In IIIs cIaµIer.
THE RELATÌONSHÌP BETWEEN THE HELP-WANTED ÌNDEX (HWÌ) AND
THE UNEMPLOYMENT RATE (UN) FROM JANUARY 1969 TO JANUARY 2000
To study causality between HWÌ and UN, two indicators of labor market conditions in the
United States, Marc A. Giammatteo considered the following regression model
28
:
HWÌ
t

0

25
i 1
i
UN
t i

25
j
j
HWÌ
t j
(22.11.1)
UN
t

0

25
i 1
i
UN
t i

25
j 1
j
HWÌ
t j
(22.11.2)
To save space we will not present the actual regression results, but the main conclusion that
emerges from this study is that there is bilateral causality between the two labor market indi-
cators and this conclusion did not change when the lag length was varied. The data on HWÌ
and UN are given in the data disk.
26
T. BoIIersIev, "GeneraIIzed AuIoregressIve CondIIIonaI HeIeroscedasIIcIIy,¨ 1ourna/ oj
Icononc/rics, voI. 31, 1986, µµ. 307-326.
27
Ior deIaIIs, see DavIdson and MacKInnon, oµ. cII., µµ. 558-560.
28
Marc A. GIannaIIeo (WesI PoInI, CIass oI 2000), "TIe ReIaIIonsIIµ LeIveen IIe HeIµ
WanIed Index and IIe UnenµIoynenI RaIe,¨ unµuLIIsIed Iern µaµer. (NoIaIIons aIIered Io
conIorn Io our noIaIIon.)
ßujarati. ßasic
Ecoooæetrics, Fourth
Editioo
ModeIs
22. Iiæe 8eries
Ecoooæetrics. Forecastiog Cuauories, Z00+
CHAPTER TWENTY-TWO: TÌME SERÌES ECONOMETRÌCS: FORECASTÌNG 863
29
I an IIankIuI Io Gregory M. OgLorn and Marc C. OgLorn (WesI PoInI, CIass oI 2001) Ior
coIIecIIng and anaIyzIng IIe daIa.
ARÌMA MODELÌNG OF THE YEN/DOLLAR EXCHANGE RATE:
JANUARY 1971 TO DECEMBER 1998
29
The yen/dollar exchange rate (¥/$) is a key exchange rate. From the logarithms of the
monthly ¥/$, it was found that in the level form this exchange rate showed the typical pattern
of a nonstationary time series. But examining the frst differences, it was found that they were
stationary; the graph here pretty much resembles Figure 22.8.
Unit root analysis confrmed that the frst differences of the logs of ¥/$ were stationary.
After examining the correlogram of the log frst differences, we estimated the following
ARÌMA(1, 0, 2) model:
Y
t
 0.0034  0.9678Y
t 1
 0.5866u
t 1
 0.4057u
t 2
t  (4.3638) (67.5439) (11.4361) (7.9532) (22.11.3)
R
2
 0.1454 d  1.9803
where Y
t
 frst differences of the logs of ¥/$ and u is a white noise error term.
To save space, we have provided the data underlying the preceding analysis in the data
disk. Using these data, the reader is urged to try other models and compare their forecasting
performances.
ARCH MODEL OF THE U.S. ÌNFLATÌON RATE: JANUARY 1947 TO JANUARY 2001
To see if the ARCH effect is present in the U.S. infation rate as measured by the CPÌ, we
obtained CPÌ data from January 1947 to January 2001. The plot of the logarithms of the CPÌ
showed that the time series was nonstationary. But the plot of the frst differences of the logs
of the CPÌ, as shown in Figure 22.9, show considerable volatility even though the frst differ-
ences are stationary.
(Continued)
FIGURE 22.9 First differences of the logs of CPÌ.
50
-0.010
-0.005
0.000
0.005
0.010
0.015
0.020
55 60 65 70 75 80 85 90 95 00
Year
ßujarati. ßasic
Ecoooæetrics, Fourth
Editioo
ModeIs
22. Iiæe 8eries
Ecoooæetrics. Forecastiog Cuauories, Z00+
864 PART FOUR: SÌMULTANEOUS-EQUATÌON MODELS
Following the procedure outlined in regressions (22.10.12) and (22.10.13), we frst re-
gressed the logged frst differences of CPÌ on a constant and obtained residuals from this
equation. Squaring these residuals, we obtained the following ARCH(3) model:
u
2
t
 0.000052  0.3399u
2
t 1
 0.1338u
2
t 2
 0.0920u
2
t 3
t  (5.1893) (8.7270) (3.5620) (2.5387) (22.11.4)
R
2
 0.2153 d  2.0334
As you can see, there is quite a bit of persistence in the volatility, as volatility in the current
month depends on volatility in the preceding 3 months. The reader is advised to obtain CPÌ
data from government sources and try to see if another model does a better job, preferably a
GARCH model.
22.12 SUMMARY AND CONCLUSIONS
1. Box-1enkIns and VAR aµµroacIes Io econonIc IorecasIIng are aIIer-
naIIves Io IradIIIonaI sIngIe- and sInuIIaneous-equaIIon nodeIs.
2. To IorecasI IIe vaIues oI a IIne serIes, IIe LasIc Box-1enkIns sIraIegy
Is as IoIIovs:
u. IIrsI exanIne IIe serIes Ior sIaIIonarIIy. TIIs sIeµ can Le done Ly
conµuIIng IIe auIocorreIaIIon IuncIIon (ACI) and IIe µarIIaI auIocorreIa-
IIon IuncIIon (PACI) or Ly a IornaI unII rooI anaIysIs. TIe correIograns
assocIaIed vIII ACI and PACI are oIIen good vIsuaI dIagnosIIc IooIs.
b. II IIe IIne serIes Is noI sIaIIonary, dIIIerence II one or nore IInes Io
acIIeve sIaIIonarIIy.
c. TIe ACI and PACI oI IIe sIaIIonary IIne serIes are IIen conµuIed Io
hnd ouI II IIe serIes Is µureIy auIoregressIve or µureIy oI IIe novIng average
Iyµe or a nIxIure oI IIe Ivo. Iron Lroad guIdeIInes gIven In TaLIe 22.1 one
can IIen deIernIne IIe vaIues oI p and q In IIe ARMA µrocess Io Le hIIed.
AI IIIs sIage IIe cIosen ARMA(p, q) nodeI Is IenIaIIve.
d. TIe IenIaIIve nodeI Is IIen esIInaIed.
e. TIe resIduaIs Iron IIIs IenIaIIve nodeI are exanIned Io hnd ouI II
IIey are vIIIe noIse. II IIey are, IIe IenIaIIve nodeI Is µroLaLIy a good
aµµroxInaIIon Io IIe underIyIng sIocIasIIc µrocess. II IIey are noI, IIe
µrocess Is sIarIed aII over agaIn. TIereIore, IIe Box-1enkIns neIIod Is
IIeraIIve.
l. TIe nodeI hnaIIy seIecIed can Le used Ior IorecasIIng.
3. TIe VAR aµµroacI Io IorecasIIng consIders severaI IIne serIes aI a
IIne. TIe dIsIInguIsIIng IeaIures oI VAR are as IoIIovs:
u. II Is a IruIy sInuIIaneous sysIen In IIaI aII varIaLIes are regarded as
endogenous.
ARCH MODEL OF THE U.S. ÌNFLATÌON RATE: . . . (Continued)