For a set of n time series variables yt ( y1t , y 2t , ..., y nt )' , a VAR model of order p
(VAR(p)) can be written as:
(1) yt A1 yt 1 A2 yt 2 ... Ap yt p ut
where the Ai ’s are (nxn) coefficient matrices and ut (u1t , u 2t ,..., u nt )' is an unobservable
i.i.d. zero mean error term.
VAR Analysis
(Enders Chapter 5)
In matrix form:
1 b12 yt b10 c11 c12 yt 1 yt
(3) b
21 1 zt b20 c21 c22 zt 1 zt
More simply:
(4) BX t 0 1 X t 1 t Structural VAR (SVAR) or the Primitive
System
These error terms are composites of the structural innovations from the primitive system.
VAR 1
Thus
e1t 1 1 b12 yt
(7) e 1 zt
2t (1 b21b12 ) b21
Or
yt b12 zt
e1t where 1 b21b12
b21 yt zt
e2t
So the shocks in a standard VAR are correlated. The only way to remove the correlation and
make the covar=0 is if we assume that the contemporaneous effects are zero: b12 b21 0 .
Identification
We can estimate (6) with OLS, since the RHS consists of predetermined variables and the
error terms are white noise. The errors are serially uncorrelated but correlated across
equations. Although SUR could be used in these cases, here we do not need it since all the
RHS variables are identical, so there is no efficiency gain in using SUR over OLS. But we
cannot use OLS to estimate the SVAR because of contemporaneous effects, which are
correlated with the ' s (structural innovations).
Our goal:
To see how a structural innovation it affects the dependent variables in our original model.
We estimate the reduced form (standard VAR), so how can we recover the parameters for the
primitive system from the estimated system?
VAR 2
VAR: 9 parameters ( = 6 coefficient estimates+ 2 variance estimates + 1 Covar
estimate).
SVAR: 10 parameters (=8 parameters + 2 variances). It is underidentified.
Sims (1980) suggested using a recursive system. For this we need to restrict some of the
parameters in the VAR. Ex: assume y is contemporaneously affected by z but not vice-versa.
Thus we assume that b21 0 . In other words, y is affected by both structural innovations of
y and z, while z is affected only by its own structural innovation. This is a triangular
decomposition also called Cholesky decomposition. Then we have 9 parameter estimates
and 9 unknown structural parameters, and SVAR is exactly identified.
1 1 b12 1 b12
B 1 .
(1 b21b12 ) b21 1
0 1
VAR 3
First, consider the first component on the RHS:
Stability requires that the roots of I A1 L lie outside the unit circle. We will assume that it
is the case. Then, we can write the second component as:
i
et a11 a12 e1,t i
i 0
i
Ae
1 t i
i 0 e
I A1 L a21 a22 2,t i
We can thus write the VAR as a VMA with the standard VAR’s error terms.
i
yt y a11 a12 e1,t i
(9) z z i 0 a e
t 21 a 22
2,t i
Ai
But these are composite errors consisting of the structural innovations. We must thus replace
1 1 b12
the e’s with the ' s from (7) et t
b21 1
yt y Ai 1 b12 y ,t i i
y 11
(i )
12
(i )
y ,t i
(9a) z t z i 0
1 b12 b21 21 b 1
z ,t i z
i0 (i )
i 21 (22i ) z ,t i
X i0 i t i .
Impact multipliers
They trace the impact effect of a one unit change in a structural innovation. Ex: find the
impact effect of z ,t on yt and zt :
dyt dzt
12 (0) 22 (0)
d z ,t d z ,t
Lets trace the effect one period ahead on yt 1 and zt 1
dyt 1 dz t 1
12 (1) 22 (1)
d z ,t d z ,t
Note that this is the same effect on yt and zt of a structural innovation one period ago:
VAR 4
dyt dzt
12 (1) 22 (1)
d z ,t 1 d z ,t 1
Impulse response functions are the plots of the effect of z ,t on current and all future y and
z. IRs show how { yt } or {zt } react to different shocks.
Ex:
Impulse response function of y to a one unit change in the shock to z
= 12 (0) , 12 (1) , 12 (2) , …
i0 12 (i ) .
n
Cumulated effect is the sum over IR functions:
In practice we cannot calculate these effects since the SVAR is underidentified. So we must
impose additional restrictions on the VAR to identify the impulse responses.
If we use the Cholesky decomposition and assume that y does not have a contemporaneous
effect on z, then b12 0 . Thus the error structure becomes lower triangular:
e1t 1 b12 yt
(10) e
2 t 0 1 zt
The y shock doesn’t affect z directly but it affects it indirectly through its lagged effect in
VAR.
Granger Causality: If the z shock affects e1, e2 and the y shock doesn’t affect e2 but it
affects e1, then z is causally prior to y.
Example:
Calculate the impulse response functions on { yt } , {zt } of a unit change in z shock ( zt )
from an estimate of a two-variable VAR(1):
yt 0.7 yt 1 0.2 zt 1 e1t
z t 0.2 yt 1 0.7 z t 1 e2t
12 22 and 12 0.8 .
For this, we must get the estimates of the primitive function (SVAR) from the estimated
coefficients:
Assume Cholesky decomposition b21 0 .
Cov1, 2 b12 2
12 0.8 b12 0.8
SE1SE2 2
Although this information is sufficient to calculate the impulse responses in this simple
model, we can extract all of the coefficients of the primitive system as follows:
a10 a20 0 b20 0
VAR 5
b10 b12b20 0 b10 0
a22 c22 0.7 and a21 c21 0.2
From a11 0.7 c11 b12c21 we get c11 0.54 .
From a11 0.7 c11 b12c21
and a12 0.7 c12 b12c22 c12 0.8(0.7) c12 0.36 and c11 0.54
Impact multipliers:
(11) yt 0.7 yt 1 0.2 zt 1 yt 0.8 zt
zt 0.2 yt 1 0.7 zt 1 zt
dy dzt
At t=0: d 0.8
t
1
z ,t d z ,t
dy
Cumulative multipliers: i 0 d 0.8 0.76 0.70 ..
n t i
z ,t
dzt i
i 0
n
1 0.86 0.75 ...
d z ,t
Results are ordering-dependent. If you choose the decomposition such that b12 0
instead of b12 , you can have quite different results. One robustness check is,
therefore to change the ordering. If results don’t change then the estimates are robust
to ordering.
If the correlation between the errors is low ( 12 small), then changing ordering does
not make a big difference.
Eviews specification
VAR 6
-Residual: ignores the correlations in the VAR residuals; gives the MA
coefficients of the infinite MA representation of the VAR.
-Cholesky (with and without degree of freedom adjustment for small sample
correction).
-Generalized impulses: Pesaran and Shin (1998) methodology. Independent
of the VAR ordering. Applies a Cholesky factorization to each variable with
the j-th variable at the top of the ordering.
VAR 7
Confidence Intervals
Help to see the degree of precision in the coefficient estimates. Obtained by Monte Carlo
study. Eviews provides two types of calculations of standard errors for the confidence
intervals: Monte Carlo and Analytic. For M-C you need to provide the number of draws.
Eviews then gives the 2 SE standard bands around the impulse responses.
Note that for VECM, these confidence intervals are not available on Eviews. For those
interested in programming themselves, instructions to generate confidence bounds for
SVARS are available at: http://www.eviews.com/support/examples/docs/svar.htm#blanquah3
Variance Decomposition
It tells how much of a change in a variable is due to its own shock and how much due to
shocks to other variables. In the SR most of the variation is due to own shock. But as the
lagged variables’ effect starts kicking in, the percentage of the effect of other shocks
increases over time.
i
yt y Ai 1 b12 y ,t i i
xt i 0 y 11
(i )
12
(i )
y ,t i
zt z 1 b12 b21 b21 1 z ,t i i 0 ( i )
i
z 21 (22i ) z ,t i
or xt X i 0 i t i .
We want to calculate the n-period forecast error of x in order to find that of say, y.
Now consider y, the first element of the x matrix. Its n-step-ahead forecast error is:
VAR 8
yt n Eyt n (11, 0 y ,t n 11,1 y ,t n1 ... 11,n1 y ,t 1 )
( 21, 0 z ,t n 21,1 z ,t n1 ... 21,n 1 z ,t 1 )
2
z
( 2 21, 0
2
21,1
...
2
21, n 1
)
proportion of var iance
due to a z shock
If z can explain none of the forecast error var of the sequence { yt } at all forecast
horizons ( y2,n z2 0 ), then { yt } is exogenous.
If z can explain most of the forecast error var of the sequence { yt } at all forecast
horizons ( y2,n z2 0.9 for ex.), then { yt } is endogenous.
Note that exogeneity is not the same as Granger-causality. It is a concept involving the
contemporaneous value of an endogenous variable and the contemporaneous error term of
another variable.
Same identification problem as for the impulse response functions. But if the cross-
correlation is not significant then ordering will not matter.
Hypothesis Testing
VAR 9
m=#parameters estimated in each equation of the unrestricted system, including the
constant.
ln r natural log of the determinant of the covariance matrix of residuals of the
restricted system.
q = total number of restrictions in the system (=#lags times n 2 ) and n=#variables (or
equations).
If the LR statistics < critical value, reject the null of the restricted system.
However, if you want to compare say, 12th lag with 8th lag, you have to do calculate the
test statistics yourself, using the formula in (10).
b. Information criteria
AIC T ln 2 N
SBC T ln N ln T
Choose the # lag that minimizes the criteria.
Note that these criteria are not tests, they mainly indicate goodness of fit of alternatives.
So they should be used as complements to the LR tests.
Autocorrelation LM Test.
Null hypothesis:
no autocorrelation up to lag h.
LM statistics distributed 2 dof = n 2 .
Normality tests
VAR 10
Multivariate version of the Jarque Bera tests. It compares the 3rd and 4th moments
(skewness and kurtosis) to those from a normal distribution. Must specify a
factorization of the residuals. Choices in Eviews:
Cholesky: the statistics will depend on the ordering of the variables.
Doornik and Hansen (94) –Inverse SQRT of residual correlation matrix:
invariant to the ordering of variables and the scale of the variables in the
system.
Urzua (97)- Inverse SQRT of residual covariance matrix: same advantage as
Doornick and Hansen, but better.
Factorization from SVAR (later: need to have estimated an SVAR)
4. Granger Causality
In a two-variable VAR(p)The process {zt } does not G-cause { yt } if all coefficients in
A12 ( L) 0 (or a joint test of a21 (1) a21 ( 2) ... a21 ( p ) 0 at all lags is not rejected).
This concept involves the effect of past values of z on the current value of y. So it answers
the question whether past and current values of z help predict the future value of y.
It is different from exogeneity tests, which look at whether the current values of z
explains current and future values of y.
Application
Create a bivariate VAR(1) and apply the tests to get the best specification of the model.
Workfile:ENDERSQUARTERLY.wf
or: endersquartdummies.prg
smpl @all
inf=log(ppi)-log(ppi(-1))
m=log(m1nsa)-log(m1nsa(-1))
for !j=1 to 4
series d{!j}=@seas({!j})
next
VAR 11
Now we can create our bivariate VAR(1):
Endogenous variables: m, inf
Exogenous variables: constant, 4 seasonal dummies
You may have priors and want to test for lag length yourself using a LR test. Suppose we
start with 12 lags and compare it with 8 lags.
VAR 12
Estimate with 12 lags the unrestricted VAR
Determinant resid
covariance (dof adj.) 1.10E-08
Determinant resid
covariance 7.41E-09
Log likelihood 1017.509
Akaike information
criterion -12.32704
Schwarz criterion -11.23222
Estimate with 8 lags over the same VAR over the same sample:
Determinant resid
covariance (dof adj.) 1.10E-08
Determinant resid
covariance 8.41E-09
Log likelihood 1033.418
Akaike information
criterion -12.41773
Schwarz criterion -11.64894
To do the comparison properly, we must use the same sample of 12 lags (1963q2 2002q1)
Determinant resid 1.14E-08
covariance (dof adj.)
Determinant resid
covariance 8.65E-09
Log likelihood 1005.422
Akaike information
criterion -12.37721
Schwarz criterion -11.59520
VAR 13
3. Diagnostic tests of the residuals
View-Residual tests-
Portmanteau test:
*The test is valid only for lags larger than the VAR lag order.
df is degrees of freedom for (approximate) chi-square distribution
LM test
1 2.327028 0.6759
2 4.861899 0.3018
3 15.30102 0.0041
4 5.459386 0.2433
5 9.271766 0.0547
6 2.422662 0.6585
7 3.174393 0.5291
8 2.091522 0.7189
VAR 14
9 0.727926 0.9478
10 4.659113 0.3241
11 8.771122 0.0671
12 1.905281 0.7532
Chisqr(4)=14.86
Mostly not reject the null.
Normality Test
1 3.975057 2 0.1370
2 21.61843 2 0.0000
The null is a joint test of both the skewness and the kurtosis.
Normality not rejected for inf but rejected for m due to kurtosis problem.
Is this something we should worry about? in principle rejection of normal distribution invalidates the
test statistics. But measures of skewness are found to be not informative in small samples (Bai, Ng
Boston College WP 115, 2001).
VAR 15
4. Granger causality
View-lag structure-G-causality/block exogeneity test
M 7.107555 5 0.2128
Dependent variable: M
Chisqr(5)=16.75
It tests bilaterally whether the lags of the excluded variable affect the endogenous variable.
The null: the lagged coefficients are significantly different than 0.
All: joint test that the lags of all other variables affect the endogenous variable.
Ex: on top panel, first row shows if lagged variables of M are significantly different than 0,
the second row shows if lagged variables of all variables other than INF are zero (in our case
both tests are identical since we only have two variables).
For both the null is rejected, though there is some evidence about effect of inf on m at 10 %
significance level.
VAR 16