HE2004/HE204A Introductory Econometrics

Semester 1, 2013 Autocorrelation

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Introduction

When dealing with time series data, observations are often correlated across time. Violates the CLR assumption of uncorrelated errors. In this section we look at
1 2 3 4

the nature of autocorrelation consequences of autocorrelation detection of autocorrelation remedial measures.

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Nature of autocorrelation
Observations in dierent time periods are correlated, i.e. E (ui uj ) 6= 0 for i 6= j . "Autocorrelation" and "serial correlation" Reasons for autocorrelation:
1 2 3 4 5 6 7

Graphically, "stickiness" of the errors (estimated) suggest correlation.

Most economic series exhibit business cycles. Omitted variables. Incorrect functional form. Cobweb phenomenon. Data manipulation e.g. smoothing, interpolation, extrapolation Transformation of model e.g. rst dierencing. Non-stationarity in dependent and independent variables.
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What implication is autocorrelation for OLS estimation? Consider the two-variable model:

[6.1] [6.2]

Yt = 1 + 2 Xt + u t ut = ut
1

+ t ,

1<<1

t satises the standard OLS assumptions:

[6.3] [6.4] [6.5]

E ( t ) = 0 var (t ) = 2 cov (t , t +s ) = 0, s 6= 0

An error term with the preceding properties is often referred to as a white noise. ut is said to follow a rst-order autoregressive process, or AR(1) process. For 1 < < 1, the error ut is stationary, i.e. constant mean, variance and covariances depend on the time interval between the errors.
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It can be shown that

[6.6] [6.7] [6.8] [6.9]

E ( ut ) = 0
2) = var (ut ) = E (ut 2 1 2
2

cov (ut , ut +s ) = E (ut , ut +s ) = s 1 2 , cor (ut , ut +s ) = s

s = 0, 1, 2, ....

Under the standard OLS assumptions, the OLS estimator of 2 is

[6.10]

where xi = Xi

b 2 =

x i y i xi2

X and yi = Yi
2 xi2

Y , and its variance is

[6.11]

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var (b 2 ) =

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Under AR(1) errors, however, the variance of [6.10] is

[6.12]

2 xt2

var (b 2 )AR 1 =

t xt 1 + 2 x x2 t

t xt 2 + 22 x + x2 t

+ 2n

1 22 x 1 x n xt2

Note the [6.12] is not the same as [6.11], unless = 0. So, usual OLS variance is a biased estimator of the true variance. The true variance [6.12] depends on the sample correlation between the X values, so it is sample dependent. In general, it is not possible to tell if var (b 2 ) > var (b 2 )AR 1 or var (b 2 ) < var (b 2 )AR 1 . Hence, inference based on [6.11] would be incorrect. What about the linear unbiased property of OLS? Under autocorrelation OLS estimator continues to be linear and unbiased. But it is not "best", ie. it is not e cient. Within the class of linear unbiased estimators, there is a more e cient estimator.
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BLUE under Autocorrelation

Lag [6.1] by 1 period and multiply by to get

[6.13]

Yt

= 1 + 2 Xt

+ ut

Subtract [6.13] from [6.1]:

[6.14]

Yt

Yt ut

1 1

= (1

) 1 + 2 ( Xt

Xt

1 ) + vt

where vt = ut Note that

[6.16]

E ( v t ) = E ( ut

ut

1)

=0

var (vt ) = var (t ) = 2

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BLUE of 2 is obtained by OLS on [6.14]

[6.17] [6.18]

Equation [6.17] is not feasible since usually we do not know . A feasible version of it involves estimating which we will discuss later.

n t =2 (x t x t 1 )(y t y t 2 n t =2 (x t x t 1 ) GLS 2 var (b 2 ) = n (xt xt 1 )2 t =2

GLS b 2 =

1)

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Consequences of OLS in Autocorrelation

Under autocorrelation, OLS continues to be linear, unbiased, consistent and asymptotically normal, if the other standard assumptions hold. But it is no longer e cient. What about the usual hypothesis testing procedures? Hypotheses testing based on var (b ) is clearly invalid.
2

2 / (n b 2 = u The residual variance bt 2) is likely to underestimate the 2 true variance . When there is AR(1) in the error term

[6.19]

1 n 2 where r = n t =1 xt xt 1 / t =1 xt , which can be interpreted as the sample correlation coe cient between successive values of the X 0 s .
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b2 ) = E (

2 fn [2 /(1 )] 2 r g n 2

Another source of downward biasedness of the estimate of var (b 2 ) can be seen by comparing [6.11] and [6.12]. If > 0 and the X 0 s are positively correlated, then var (b 2 ) < var (b 2 )AR 1 . Hypotheses testing based on var (b 2 )AR 1 , while valid, generally lacks power.

b2 ) < 2 , i.e. the usual residual If both > 0 and r > 0, then E ( variance will underestimate the true variance. This will then lead to downward bias of the estimate of var (b 2 ) since we typically estimate 2 2 b /xt . it by

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