MACROECONOMETRICS

LAB 3 DYNAMIC MODELS

ROADMAP

What if we know that the effect lasts in time?

Distributed lags

ALMON

KOYCK

ADAPTIVE EXPECTATIONS

PARTIAL ADJUSTMENT

STATA not really too complicated here

How to do lags?

Infinite?

how many lags do we take?

how to know?

Unrestricted?

do we impose any structure on the lags?

this structure might be untrue?
but there is also cost to unrestricted approach...

Unrestricted lags (no structure)

It is always finite!

yt = + 0 xt + 1 xt-1 + 2 xt-2 + . . . +n xt-n + et

N lags and no structure in parameters
OLS works

BUT
n observations lost
high multicollinearity

imprecise, large s.e., low t, lots of d.f. Lost

STRUCTURE COULD HELP

Arithmetic lag

The effect of X eventually zero

Linearly!
The coefficients not independent of each other

effect of each lag less than previous

exactly like arithmetic series: un=u1+d(n-1)

Arithmetic lag - structure

i

0 = (n+1)
1 = n

Linear
lag

2 = (n-1)

structure

.
.
.
n =
0

n+1 i

Arithmetic lag - maths

X (log of) money supply and Y (log of) GDP, n=12 and is
estimated to be 0.1
the effect of a change in x on GDP in the current period is
(n+1)=1.3

the impact of monetary policy one period later has declined to

n=1.2

n periods later, the impact is n 0.1

n+1 periods later the impact is zero

E ( yt )
i
xt i

Arithmetic lag - estimation

OLS, only need to estimate one parameter:

STEP 1: impose restriction

yt = + 0 xt + 1 xt-1 + 2 xt-2 + . . . +n xt-n + et

STEP 2: factor out the parameter

yt = + [(n+1)xt + nxt-1 + (n-1)xt-2 + . . . + xt-n] + et

STEP 3: define z

zt = [(n+1)xt + nxt-1 + (n-1)xt-2 + . . . + xt-n]

STEP 4: decide n (no. of lags)

For n = 4:

???
zt = [ 5xt + 4xt-1 + 3xt-2 + 2xt-3 + xt-4]

Arithmetic lag pros & cons

Advantages:

Only one parameter to be estimated!

Straightforward interpretation

Disadvantages:

t-statistics ok., better s.e., results more reliable

If restriction untrue, estimators biased and inconsistent

Solution? F-test! (see: end of the notes)

Polynomial lag (ALMON)

If we want a different shape of IRF...

Its just a different shape

Still finite: the effect eventually goes to zero
(by DEFINITION and not by nature!)
The coefficients still related to each other BUT not a uniform
pattern (decline)

Polynomial lag - structure

2

. . .

1
0

.
0

i = 0 + 1i + 2i

E ( yt )
i
xt i

Polynomial lag - maths

n the lenght of the lag

p degree of the polynomial

i = 0 + 1i + 2i2 +...+ pip, where i=1, . . . , n

For example a quadratic polynomial

i = 0 + 1i + 2i2 , where p=2

0 = 0
2 = 0 + 21 + 42
4 = 0 + 41 + 162

and

n=4

1 = 0 + 1 + 2
3 = 0 + 31 + 92

Polynomial lags - estimation

OLS, only need to estimate p parameters: p

STEP 1: impose restriction

yt = +0xt + 0 + 1 + 2xt-1+(0 +21 +42)xt-2+(0+31 +92)xt-3+

(0 +41 + 162)xt-4 + et

STEP 2: factor out the unknown coefficients

yt = +0 [xt +xt-1+xt-2+xt-3 +xt-4]+1[xt+xt-1+2xt-2+3xt-3 +4xt-4] +

2 define
[xt + xt-1
STEP 3:
z + 4xt-2 + 9xt-3 + 16xt-4] + et

t0
t OLS
t-1 on y
t-2 = t-3
t1
STEP
4: do
+ 0 z t-4
t
t0 + 1 z t1 + 2 z t2 + et

z = [x + x + x + x + x ]
z
z t2 = [xt + xt-1 + 4xt-2 + 9xt-3 + 16xt- 4]

= [xt + xt-1 + 2xt-2 + 3xt-3 + 4xt- 4 ]

Polynomial lag pros & cons

Advantages:

Fewer parameters to be estimated than in the unrestricted lag

structure

If the polynomial restriction likely to be true:

More precise than unrestricted

More flexible than arithmetic DL

Disadvantages
If the restriction untrue, biased and inconsistent
(see F-test in the end of the notes)

Arithmetic vs. Polynomial vs. ???

Conclusion no. 1

Conclusion no. 2

Data should decide about the assumed pattern of impulseresponse function

We still do not know, how many lags!

Conclusion no. 3

We still have a finite no. of lags.

Geometric lag (KOYCK)

Distributed lag is infinite infinite lag length (no time limits)

BUT cannot estimate an infinite number of parameters!
Restrict the lag coefficients to follow a pattern

For the geometric lag the pattern is one of continuous decline at

decreasing rate
(we are still stuck with the problem of imposing fading out instead
of observing it gladly, it is not really painful, as most processes
behave like that anyway )

Geometric lag - structure

i

0 =

.
.

1 =
2 = 2
3 = 3
4 = 4

Geometrically
declining
weights

.
2

. .
3

Geometric lag - maths

Infinite distributed lag model

yt = + 0 xt + 1 xt-1 + 2 xt-2 + . . . + et
yt = + i xt-i + et

Geometric lag structure

i = i
where || < 1 and i

Infinite unstructured geometric lag model

yt = + 0 xt + 1 xt-1 + 2 xt-2 + 3 xt-3 + . . . + et
AND:0=1=2=23=3 ...
Substitute i = i => infinite geometric lag
yt = + xt + xt-1 + xt-2 + xt-3 + . . .) + et

Geometric lag - estimation

Cannot estimate using OLS

yt-1 is dependent on et-1 cannot alow that (need to instrument)

Apply Koyck transformation

Then use 2SLS
Only need to estimate two parameters:
Have to do some algebra to rewrite the model in form
that can be estimated.

Geometric lag Koyck transformation

Original equation:
yt = + xt + xt-1 + xt-2 + xt-3 + . . .) + et
Koyck rule: lag everything once, multiply by and
substract from the original
yt = + xt + xt-1 + xt-2 + xt-3 + . . .) + et
yt-1 = + xt-1 + xt-2 + xt-3 + . . .) + et-1

yt yt-1 = + xt + (et et-1)

yt = + yt-1 + xt + (et et-1) so yt = + yt-1 + xt + t

yt-1 is dependent on et-1 so yt-1 is correlated with vt-1

OLS will be consistent (it cannot distinguish between change in yt
caused by yt-1 that caused by vt)

Geometric lag - estimation

Regress yt-1 on xt-1 and calculate the fitted value

Use the fitted value in place of yt-1 in the Koyck

regression and that is it!
Why does this work?

from the first stage fitted value is not correlated with et-1 but yt-1
is so fitted value is uncorrelated with vt =(et -et-1 )

2SLS will produce consistent estimates of the

Geometric Lag Model

Geometric lag pros & cons

Advantages

Disadvantages

You only estimate two parameters!

We allow neither for heterogenous nor for unsmooth declining

It has many well specified versions, among which two

have particular importance:
ADAPTIVE EXPECTATIONS
PARTIAL ADJUSTMENT MODEL
(for both: see next student presentation)

F-tests of restrictions
1.
2.
3.

Estimate the unrestricted model

Estimate the restricted (any lag) model
Calculate the test statistic

( SSE R SSEU ) / df1

F
SSEU / df 2

4.

Compare with critical value F(df1,df2)

5.

df1 = number of restrictions

df2 = number of observations-number of variables in the unrestricted
model (incl. constant)

H0: residuals are the same, restricted model OK