Assumptions on the Disturbance Term in a Regression Model

The assumptions are:

E(U
i
) = 0 , i = 1,2, .N
E(U
i
U
j
) = 0 , i j
=
2
u
, i = j
I,j = 1,2,N
E(X
i
U
i
) = X
i
E(U
i
)= 0 , for all i, j
The u
i
are iid N(o,
2
)
Which reads, the U
i
are independently and identically distributed
normal variables with zero mean and variance
2
. The validity of
the inference procedures obviously depends on the correctness of
the underpinning assumptions.
Autocorrelation
The second assumption is that the error termsdisturbances are
pairwise uncorrelated. !n other words, the U terms of all
observations are all statistically independent and not interrelated.
When this condition of mutual statistical independence of
disturbance fails, the disturbances are said to be autocorrelated or
seriall correlated.
Reasons for Autocorrelated Disturbances
!n the specification " # $ + u, one hopes to include all relevant
variables in the $ matri% and therefore the disturbance would be
e%pected to be serially uncorrelated.
Significantly autocorrelated disturbances ould thus be
an indication of an inade!uate specification"
Autocorrelation ould occur, if the #ariables that ha#e
influence on the dependent #ariable are omitted for
con#enience (lac$ of data) or because of inade!uate
$noledge of the structure
%onse!uences
The presence of autocorrelation ma&es '() estimators less
efficient. *ecause the variance of the estimator is affected,
the estimate of the confidence interval also become less
reliable.
The sampling variances are biased and sometimes li&ely to be
seriously understated. Thus R
2
as well as t and F statistics
tend to be e%aggerated.
+utocorrelation, however, does not affect the property of
un!iasedness, nor is the property of consistenc necessarily
affected.
The combination of a lagged dependent variable in $ and an
autocorrelated disturbance renders '() inconsistent.
&orms of Autocorrelation: AR and MA Schemes
,ost common )pecification - first.order +/012 process , or
U
t
# U
t.1
3
t
012
Where
t
is a white noise process. The necessary and sufficient
condition for a stationary disturbance process is | | ' (. The
constant e%pectation for Ut and the constant variance, given
stationary condition, respectively are as follows4
5 0U
t
2 # 6 for all t
+nd auto correlation coeffcients are
s
#
s
for s # 6,1,2,7.
The auto correlation coeffcients starts at
6
#1 and then decline
e%ponentially but never disappear. The current disturbance is a
weighted sum of of the current shoc& andall previous shoc&s but
the more distant shoc&s receive ever.declining weights as
follows4

U
t
#
t
3
t.1
3
2

t.2
3 7..
,+012 scheme - U
t
#
t
3
t.1

1
# 013
2
2

i
# 6 i # 2, 8 77
2
2
2
1
2 0

= =
u t
U "ar
2 1 0 2 0
2 2 2


+ = =
u t
U "ar
Test for Autocorrelated Disturbances
Durbin)*atson Test 0Test of first order autocorrelation2

d 2(())
+ ' d ' ,
d ' 2 for positi#e autocorrelation of the e-s
d . 2 for negati#e autocorrelation of the e-s
d 2 for /ero autocorrelation of the e-s
&or testing 0
+
: 1 + aginst 0
(
: . +
1. !f d < d
L
, reject Ho
2. !f d > d
u
, Do not reject Ho
8. !f d
L
' d < d
u
, the test is inclusive
&or testing 0
+
: 1 + aginst 0
(
: ' +
1. !f 9 2 d < d
L
, reject Ho
2. !f 9 d > d
u
, Do not reject Ho
8. !f d
L
' 9 2 d < d
u
, the test is inclusive

=
=

= =

=
=

+
=

=
n
t
t
n
t
t
n
t
t
n
t
t t
n
t
t
n
t
t t
e
e e e e
e
e e
d
1
2
2
1
2 2
1
2 2
1
2
2
1
2 0 2 2 0