A study guide produced by Christopher Dougherty to accompany the module "EC2020 Elements of Econometrics" offered as part of the University

of London
International Programmes in Economics, Management, Finance, and the Social Sciences.

Chapter 11
Models using time series data

11.1 Overview
This chapter introduces the application of regression analysis to time series data,
beginning with static models and then proceeding to dynamic models with lagged
variables used as explanatory variables. It is shown that multicollinearity is likely to be
a problem in models with unrestricted lag structures and that this provides an incentive
to use a parsimonious lag structure, such as the Koyck distribution. Two models using
the Koyck distribution, the adaptive expectations model and the partial adjustment
model, are described, together with well-known applications to aggregate consumption
theory, Friedman’s permanent income hypothesis in the case of the former and Brown’s
habit persistence consumption function in the case of the latter. The chapter concludes
with a discussion of prediction and stability tests in time series models.

11.2 Learning outcomes

After working through the corresponding chapter in the text, studying the
corresponding slideshows, and doing the starred exercises in the text and the additional
exercises in this subject guide, you should be able to:

explain why multicollinearity is a common problem in time series models, especially

dynamic ones with lagged explanatory variables

describe the properties of a model with a lagged dependent variable (ADL(1,0)

model)

describe the assumptions underlying the adaptive expectations and partial

adjustment models

explain the properties of OLS estimators of the parameters of ADL(1,0) models

explain how predetermined variables may be used as instruments in the fitting of

models using time series data

explain in general terms the objectives of time series analysts and those
constructing VAR models.

239
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Published on the Online Resource Centre to accompany Dougherty: Introduction to Econometrics, 5th edition, by Oxford University Press.
A study guide produced by Christopher Dougherty to accompany the module "EC2020 Elements of Econometrics" offered as part of the University of London
International Programmes in Economics, Management, Finance, and the Social Sciences.

11. Models using time series data

11.3 Additional exercises

A11.1 The output below shows the result of linear and logarithmic regressions of
expenditure on food on income, relative price, and population (measured in
thousands) using the Demand Functions data set, together with the correlations
among the variables. Provide an interpretation of the regression coefficients and
perform appropriate statistical tests.

============================================================
Dependent Variable: FOOD
Method: Least Squares
Sample: 1959 2003
Included observations: 45
============================================================
Variable Coefficient Std. Error t-Statistic Prob.
============================================================
C -19.49285 88.86914 -0.219343 0.8275
DPI 0.031713 0.010658 2.975401 0.0049
PRELFOOD 0.403356 0.365133 1.104681 0.2757
POP 0.001140 0.000563 2.024017 0.0495
============================================================
R-squared 0.988529 Mean dependent var 422.0374
Adjusted R-squared 0.987690 S.D. dependent var 91.58053
S.E. of regression 10.16104 Akaike info criteri7.559685
Sum squared resid 4233.113 Schwarz criterion 7.720278
Log likelihood -166.0929 F-statistic 1177.745
Durbin-Watson stat 0.404076 Prob(F-statistic) 0.000000
============================================================

============================================================
Dependent Variable: LGFOOD
Method: Least Squares
Sample: 1959 2003
Included observations: 45
============================================================
Variable Coefficient Std. Error t-Statistic Prob.
============================================================
C 5.293654 2.762757 1.916077 0.0623
LGDPI 0.589239 0.080158 7.351014 0.0000
LGPRFOOD -0.122598 0.084355 -1.453361 0.1537
LGPOP -0.289219 0.258762 -1.117706 0.2702
============================================================
R-squared 0.992245 Mean dependent var 6.021331
Adjusted R-squared 0.991678 S.D. dependent var 0.222787
S.E. of regression 0.020324 Akaike info criter-4.869317
Sum squared resid 0.016936 Schwarz criterion -4.708725
Log likelihood 113.5596 F-statistic 1748.637
Durbin-Watson stat 0.488502 Prob(F-statistic) 0.000000
============================================================

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Published on the Online Resource Centre to accompany Dougherty: Introduction to Econometrics, 5th edition, by Oxford University Press.
A study guide produced by Christopher Dougherty to accompany the module "EC2020 Elements of Econometrics" offered as part of the University of London
International Programmes in Economics, Management, Finance, and the Social Sciences.

11.3. Additional exercises

Correlation Matrix
============================================================
LGFOOD LGDPI LGPRFOOD LGPOP
============================================================
LGFOOD 1.000000 0.995896 -0.613437 0.990566
LGDPI 0.995896 1.000000 -0.604658 0.995241
LGPRFOOD -0.613437 -0.604658 1.000000 -0.641226
LGPOP 0.990566 0.995241 -0.641226 1.000000
============================================================

A11.2 Perform regressions parallel to those in Exercise A11.1 using your category of
expenditure and provide an interpretation of the coefficients.

A11.3 The output shows the result of a logarithmic regression of expenditure on food per
capita, on income per capita, both measured in US$ million, and the relative price
index for food. Provide an interpretation of the coefficients, demonstrate that the
specification is a restricted version of the logarithmic regression in Exercise A11.1,
and perform an F test of the restriction.

============================================================
Dependent Variable: LGFOODPC
Method: Least Squares
Sample: 1959 2003
Included observations: 45
============================================================
Variable Coefficient Std. Error t-Statistic Prob.
============================================================
C -5.425877 0.353655 -15.34231 0.0000
LGDPIPC 0.280229 0.014641 19.14024 0.0000
LGPRFOOD 0.052952 0.082588 0.641160 0.5249
============================================================
R-squared 0.927348 Mean dependent var-6.321984
Adjusted R-squared 0.923889 S.D. dependent var 0.085249
S.E. of regression 0.023519 Akaike info criter-4.597688
Sum squared resid 0.023232 Schwarz criterion -4.477244
Log likelihood 106.4480 F-statistic 268.0504
Durbin-Watson stat 0.417197 Prob(F-statistic) 0.000000
============================================================

A11.4 Perform a regression parallel to that in Exercise A11.3 using your category of
expenditure. Provide an interpretation of the coefficients, and perform an F test of
the restriction.

A11.5 The output shows the result of a logarithmic regression of expenditure on food per
capita, on income per capita, the relative price index for food, and population.
Provide an interpretation of the coefficients, demonstrate that the specification is
equivalent to that for the logarithmic regression in Exercise A11.1, and use it to
perform a t test of the restriction in Exercise A11.3.

============================================================
Dependent Variable: LGFOODPC
Method: Least Squares
Sample: 1959 2003

241
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Published on the Online Resource Centre to accompany Dougherty: Introduction to Econometrics, 5th edition, by Oxford University Press.
A study guide produced by Christopher Dougherty to accompany the module "EC2020 Elements of Econometrics" offered as part of the University of London
International Programmes in Economics, Management, Finance, and the Social Sciences.

11. Models using time series data

Included observations: 45
============================================================
Variable Coefficient Std. Error t-Statistic Prob.
============================================================
C 5.293654 2.762757 1.916077 0.0623
LGDPIPC 0.589239 0.080158 7.351014 0.0000
LGPRFOOD -0.122598 0.084355 -1.453361 0.1537
LGPOP -0.699980 0.179299 -3.903973 0.0003
============================================================
R-squared 0.947037 Mean dependent var-6.321984
Adjusted R-squared 0.943161 S.D. dependent var 0.085249
S.E. of regression 0.020324 Akaike info criter-4.869317
Sum squared resid 0.016936 Schwarz criterion -4.708725
Log likelihood 113.5596 F-statistic 244.3727
Durbin-Watson stat 0.488502 Prob(F-statistic) 0.000000
============================================================

A11.6 Perform a regression parallel to that in Exercise A11.5 using your category of
expenditure, and perform a t test of the restriction implicit in the specification in
Exercise A11.4.

A11.7 In Exercise 11.9 you fitted the model:

LGCAT = β1 + β2 LGDPI + β3 LGDPI (−1) + β4 LGPRCAT + β5 LGPRCAT (−1) + u

where CAT stands for your category of expenditure.

• Show that (β2 + β3 ) and (β4 + β5 ) are theoretically the long-run (equilibrium)
income and price elasticities.
• Reparameterise the model and fit it to obtain direct estimates of these
long-run elasticities and their standard errors.
• Confirm that the estimates are equal to the sum of the individual shortrun
elasticities found in Exercise 11.9.
• Compare the standard errors with those found in Exercise 11.9 and state your
conclusions.

A11.8 In a certain bond market, the demand for bonds, Bt , in period t is negatively
related to the expected interest rate, iet+1 , in period t + 1:

Bt = β1 + β2 iet+1 + ut (1)

where ut is a disturbance term not subject to autocorrelation. The expected

interest rate is determined by an adaptive expectations process:

iet+1 − iet = λ(it − iet ) (2)

where it is the actual rate of interest in period t. A researcher uses the following
model to fit the relationship:

Bt = γ1 + γ2 it + γ3 Bt−1 + vt (3)

where vt is a disturbance term.

242
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Published on the Online Resource Centre to accompany Dougherty: Introduction to Econometrics, 5th edition, by Oxford University Press.
A study guide produced by Christopher Dougherty to accompany the module "EC2020 Elements of Econometrics" offered as part of the University of London
International Programmes in Economics, Management, Finance, and the Social Sciences.

11.3. Additional exercises

• Show how this model may be derived from the demand function and the
adaptive expectations process.
• Explain why inconsistent estimates of the parameters will be obtained if
equation (3) is fitted using ordinary least squares (OLS). (A mathematical
proof is not required. Do not attempt to derive expressions for the bias.)
• Describe a method for fitting the model that would yield consistent estimates.
• Suppose that ut was subject to the first-order autoregressive process:

ut = ρut−1 + εt

where εt is not subject to autocorrelation. How would this affect your answer
to the second part of this question?
• Suppose that the true relationship was actually:

Bt = β1 + β2 it + ut (1∗)

with ut not subject to autocorrelation, and the model is fitted by regressing Bt

on it and Bt−1 , as in equation (3), using OLS. How would this affect the
regression results?
• How plausible do you think an adaptive expectations process is for modelling
expectations in a bond market?

A11.9 The output shows the result of a logarithmic regression of expenditure on food on
income, relative price, population, and lagged expenditure on food using the
Demand Functions data set. Provide an interpretation of the regression coefficients,
paying attention to both short-run and long-run dynamics, and perform
appropriate statistical tests.

============================================================
Dependent Variable: LGFOOD
Method: Least Squares
Sample(adjusted): 1960 2003
Included observations: 44 after adjusting endpoints
============================================================
Variable Coefficient Std. Error t-Statistic Prob.
============================================================
C 1.487645 2.072156 0.717921 0.4771
LGDPI 0.143829 0.090334 1.592194 0.1194
LGPRFOOD -0.095749 0.061118 -1.566613 0.1253
LGPOP -0.046515 0.189453 -0.245524 0.8073
LGFOOD(-1) 0.727290 0.113831 6.389195 0.0000
============================================================
R-squared 0.995886 Mean dependent var 6.030691
Adjusted R-squared 0.995464 S.D. dependent var 0.216227
S.E. of regression 0.014564 Akaike info criter-5.513937
Sum squared resid 0.008272 Schwarz criterion -5.311188
Log likelihood 126.3066 F-statistic 2359.938
Durbin-Watson stat 1.103102 Prob(F-statistic) 0.000000
============================================================

243
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Published on the Online Resource Centre to accompany Dougherty: Introduction to Econometrics, 5th edition, by Oxford University Press.
A study guide produced by Christopher Dougherty to accompany the module "EC2020 Elements of Econometrics" offered as part of the University of London
International Programmes in Economics, Management, Finance, and the Social Sciences.

11. Models using time series data

A11.10 Perform a regression parallel to that in Exercise A11.9 using your category of
expenditure. Provide an interpretation of the coefficients, and perform appropriate
statistical tests.

A11.11 In his classic study Distributed Lags and Investment Analysis (1954), Koyck
investigated the relationship between investment in railcars and the volume of
freight carried on the US railroads using data for the period 1884–1939. Assuming
that the desired stock of railcars in year t depended on the volume of freight in
year t − 1 and year t − 2 and a time trend, and assuming that investment in
railcars was subject to a partial adjustment process, he fitted the following
regression equation using OLS (standard errors and constant term not reported):

Ibt = 0.077Ft−1 + 0.017Ft−2 − 0.0033t − 0.110Kt−1 R2 = 0.85

where It = Kt − Kt−1 is investment in railcars in year t (thousands), Kt is the stock

of railcars at the end of year t (thousands), and Ft is the volume of freight handled
in year t (ton-miles).
Provide an interpretation of the equation and describe the dynamic process implied
by it. (Note: It is best to substitute Kt − Kt−1 for It in the regression and treat it
as a dynamic relationship determining Kt .)

A11.12 Two researchers agree that a model consists of the following relationships:

Yt = α1 + α2 Xt + u t (1)
Xt = β1 + β2 Yt−1 + vt (2)
Zt = γ1 + γ2 Yt + γ3 Xt + γ4 Qt + wt (3)

where ut , vt , and wt , are disturbance terms that are drawn from fixed distributions
with zero mean. It may be assumed that they are distributed independently of Qt
and of each other and that they are not subject to autocorrelation. All the
parameters may be assumed to be positive and it may be assumed that α2 β2 < 1.
• One researcher asserts that consistent estimates will be obtained if (2) is fitted
using OLS and (1) is fitted using IV, with Yt−1 as an instrument for Xt .
Determine whether this is true.
• The other researcher asserts that consistent estimates will be obtained if both
(1) and (2) are fitted using OLS, and that the estimate of β2 will be more
efficient than that obtained using IV. Determine whether this is true.

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A study guide produced by Christopher Dougherty to accompany the module "EC2020 Elements of Econometrics" offered as part of the University of London
International Programmes in Economics, Management, Finance, and the Social Sciences.

11.4. Answers to the starred exercises in the textbook

11.4 Answers to the starred exercises in the textbook

11.6
Year Y K L Year Y K L
1899 100 100 100 1911 153 216 145
1900 101 107 105 1912 177 226 152
1901 112 114 110 1913 184 236 154
1902 122 122 118 1914 169 244 149
1903 124 131 123 1915 189 266 154
1904 122 138 116 1916 225 298 182
1905 143 149 125 1917 227 335 196
1906 152 163 133 1918 223 366 200
1907 151 176 138 1919 218 387 193
1908 126 185 121 1920 231 407 193
1909 155 198 140 1921 179 417 147
1910 159 208 144 1922 240 431 161
Source: Cobb and Douglas (1928)

The table gives the data used by Cobb and Douglas (1928) to fit the original
Cobb–Douglas production function:
Yt = β1 Ktβ2 Lβt 3 vt
Yt , Kt , and Lt , being index number series for real output, real capital input, and
real labour input, respectively, for the manufacturing sector of the United States for
the period 1899–1922 (1899 = 100). The model was linearised by taking logarithms
of both sides and the following regressions was run (standard errors in parentheses):
[
log Y = −0.18 + 0.23 log K + 0.81 log L R2 = 0.96
(0.43) (0.06) (0.15)
Provide an interpretation of the regression coefficients.
Answer:
The elasticities of output with respect to capital and labour are 0.23 and 0.81,
respectively, both coefficients being significantly different from zero at very high
significance levels. The fact that the sum of the elasticities is close to one suggests
that there may be constant returns to scale. Regressing output per worker on
capital per worker, one has:
\ Y K
log = 0.01 + 0.25 log R2 = 0.63
L L
(0.02) (0.04)
The smaller standard error of the slope coefficient suggests a gain in efficiency.
Fitting a reparameterised version of the unrestricted model:
\ Y K
log = −0.18 + 0.23 log + 0.04 log L R2 = 0.64
L L
(0.43) (0.06) (0.09)
we find that the restriction is not rejected.

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A study guide produced by Christopher Dougherty to accompany the module "EC2020 Elements of Econometrics" offered as part of the University of London
International Programmes in Economics, Management, Finance, and the Social Sciences.

11. Models using time series data

11.7 The Cobb–Douglas model in Exercise 11.6 makes no allowance for the possibility
that output may be increasing as a consequence of technical progress,
independently of K and L. Technical progress is difficult to quantify and a common
way of allowing for it in a model is to include an exponential time trend:
Yt = β1 Ktβ2 Lβt 3 eρt vt
where ρ is the rate of technical progress and t is a time trend defined to be 1 in the
first year, 2 in the second, etc. The correlations between log K, log L and t are
shown in the table. Comment on the regression results.
[
log Y = 2.81 − 0.53 log K + 0.91 log L + 0.047t R2 = 0.97
(1.38) (0.34) (0.14) (0.021)
Correlation
================================================
LGK LGL TIME
================================================
LGK 1.000000 0.909562 0.996834
LGL 0.909562 1.000000 0.896344
TIME 0.996834 0.896344 1.000000
================================================
Answer:
The elasticity of output with respect to labour is higher than before, now
implausibly high given that, under constant returns to scale, it should measure the
share of wages in output. The elasticity with respect to capital is negative and
nonsensical. The coefficient of time indicates an annual exponential growth rate of
4.7 per cent, holding K and L constant. This is unrealistically high for the period
in question. The implausibility of the results, especially those relating to capital
and time (correlation 0.997), may be attributed to multicollinearity.

11.16 Demonstrate that the dynamic process (11.18) implies the long-run relationship
given by (11.15).
Answer:
Equations (11.15) and (11.18) are:
β1 β2
Ỹ = + X̃ (11.15)
1 − β3 1 − β3

Yt = β1 (1 + β3 + β32 + · · · ) + β2 Xt + β2 β3 Xt−1 + β2 β32 Xt−2 + · · · (11.18)

+ut + β3 ut−1 + β32 ut−2 + · · · .
Putting X = X̃ for all X in (11.18), and ignoring the disturbance terms, the
long-run relationship between Y and X is given by:
Ỹ = β1 (1 + β3 + β32 + · · · ) + β2 X̃ + β2 β3 X̃ + β2 β32 X̃ + · · ·
β1
= + (1 + β3 + β32 + · · · )β2 X̃
1 − β3
β1 β2
= + X̃.
1 − β3 1 − β3

246
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A study guide produced by Christopher Dougherty to accompany the module "EC2020 Elements of Econometrics" offered as part of the University of London
International Programmes in Economics, Management, Finance, and the Social Sciences.

11.4. Answers to the starred exercises in the textbook

11.17 The compound disturbance term in the adaptive expectations model (11.37) does
potentially give rise to a problem that will be discussed in Chapter 12 when we
come to the topic of autocorrelation. It can be sidestepped by representing the
model in the alternative form.

Yt = β1 + β2 λXt + β2 λ(1 − λ)Xt−1 + · · · + β2 λ(1 − λ)s Xt−s + β2 (1 − λ)s+1 Xt−s

e
+ ut .

Show how this form might be obtained, and discuss how it might be fitted.
Answer:
We start by reprising equations (11.31) – (11.34) in the text. We assume that the
e
dependent variable Yt is related to Xt+1 , the value of X anticipated in the next
time period:
e
Yt = γ1 + γ2 Xt+1 + ut . (11.31)
To make the model operational, we hypothesise that expectations are updated in
response to the discrepancy between what had been anticipated for the current
e
time period, Xt+1 , and the actual outcome, Xt :
e
Xt+1 − Xte = λ(Xt − Xte ) (11.32)

where λ may be interpreted as a speed of adjustment. We can rewrite this as

(11.33):
e
Xt+1 = λXt + (1 − λ)Xte . (11.33)
Hence we obtain (11.34):

Yt = γ1 + γ2 λXt + γ2 (1 − λ)Xte + ut . (11.34)

This includes the unobservable Xte on the right side. However, lagging (11.33), we
have:
Xte = λXt−1 + (1 − λ)Xt−1 e
.
Hence:
Yt = γ1 + γ2 λXt + γ2 λ(1 − λ)Xt−1 + γ2 (1 − λ)2 Xt−1
e
+ ut .
e
This includes the unobservable Xt−1 on the right side. However, continuing to lag
and substitute, we have:

Yt = γ1 + γ2 λXt + γ2 λ(1 − λ)Xt−1 + · · · + γ2 λ(1 − λ)s Xt−s + γ2 (1 − λ)s+1 Xt−s

e
+ ut .

Provided that s is large enough for γ2 (1 − λ)s+1 to be very small, this may be
fitted, omitting the unobservable final term, with negligible omitted variable bias.
We would fit it with a nonlinear regression technique that respected the constraints
implicit in the theoretical structure of the coefficients.

11.19 The output below shows the result of fitting the model:

LGFOOD = β1 + β2 λLGDPI + β2 λ(1 − λ)LGDPI (−1) + β2 λ(1 − λ)2 LGDPI (−2)

+β2 λ(1 − λ)3 LGDPI (−3) + β3 LGPRFOOD + u

using the data on expenditure on food in the Demand Functions data set.
LGFOOD and LGPRFOOD are the logarithms of expenditure on food and the

247
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A study guide produced by Christopher Dougherty to accompany the module "EC2020 Elements of Econometrics" offered as part of the University of London
International Programmes in Economics, Management, Finance, and the Social Sciences.

11. Models using time series data

relative price index series for food. C(1), C(2), C(3), and C(4) are estimates of β1 ,
β2 , λ and β3 , respectively. Explain how the regression equation could be interpreted
as an adaptive expectations model and discuss the dynamics implicit in it, both
short-run and long-run. Should the specification have included further lagged
values of LGDPI ?

============================================================
Dependent Variable: LGFOOD
Method: Least Squares
Sample(adjusted): 1962 2003
Included observations: 42 after adjusting endpoints
Convergence achieved after 25 iterations
LGFOOD=C(1)+C(2)*C(3)*LGDPI + C(2)*C(3)*(1-C(3))*LGDPI(-1) + C(2)
*C(3)*(1-C(3))^2*LGDPI(-2) + C(2)*C(3)*(1-C(3))^3*LGDPI(-3) +
C(4)*LGPRFOOD
============================================================
Coefficient Std. Error t-Statistic Prob.
============================================================
C(1) 2.339513 0.468550 4.993091 0.0000
C(2) 0.496425 0.012264 40.47818 0.0000
C(3) 0.915046 0.442851 2.066264 0.0457
C(4) -0.089681 0.083250 -1.077247 0.2882
============================================================
R-squared 0.989621 Mean dependent var 6.049936
Adjusted R-squared 0.988802 S.D. dependent var 0.201706
S.E. of regression 0.021345 Akaike info criter-4.765636
Sum squared resid 0.017313 Schwarz criterion -4.600143
Log likelihood 104.0784 Durbin-Watson stat 0.449978
============================================================
Answer:
Suppose that the model is:

LGFOOD t = γ1 + γ2 LGDPI et+1 + γ3 LGPRFOOD t + ut

where LGDPI et+1 is expected LGDPI at time t + 1, and that expectations for
income are subject to the adaptive expectations process:

LGDPI et+1 − LGDPI et = λ(LGDPI t − LGDPI et ).

The adaptive expectations process may be rewritten:

LGDPI et+1 = λLGDPI t + (1 − λ)LGDPI et .

Lagging this equation one period and substituting, one has:

LGDPI et+1 = λLGDPI t + λ(1 − λ)LGDPI t−1 + (1 − λ)2 LGDPI et−1 .

Lagging a second time and substituting, one has:

LGDPI et+1 = λLGDPI t +λ(1−λ)LGDPI t−1 +λ(1−λ)2 LGDPI t−2 +(1−λ)3 LGDPI et−2 .

Lagging a third time and substituting, one has:

LGDPI et+1 = λLGDPI t + λ(1 − λ)LGDPI t−1 + λ(1 − λ)2 LGDPI t−2
+λ(1 − λ)3 LGDPI et−3 + (1 − λ)4 LGDPI et−3 .

248
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International Programmes in Economics, Management, Finance, and the Social Sciences.

11.4. Answers to the starred exercises in the textbook

Substituting this into the model, dropping the final unobservable term, one has the
regression specification as stated in the question.
The estimates imply that the short-run income elasticity is 0.50. The speed of
adjustment of expectations is 0.92. Hence the long-run income elasticity is
0.50/0.92 = 0.54. The price side of the model has been assumed to be static. The
estimate of the price elasticity is −0.09. The coefficient of the dropped
unobservable term is γ2 (1 − λ)4 . Given our estimates of γ2 and λ, its estimate is
0.0003. Hence we are justified in neglecting it.

11.22 A researcher is fitting the following supply and demand model for a certain
commodity, using a sample of time series observations:
Qdt = β1 + β2 Pt + udt
Qst = α1 + α2 Pt + ust
where Qdt is the amount demanded at time t, Qst is the amount supplied, Pt is the
market clearing price, and udt and ust are disturbance terms that are not
necessarily independent of each other. It may be assumed that the market clears
and so Qdt = Qst .
• What can be said about the identification of (a) the demand equation, (b) the
supply equation?
• What difference would it make if supply at time t was determined instead by
price at time t − 1? That is:
Qst = α1 + α2 Pt−1 + ust .

• What difference would it make if it could be assumed that udt is distributed

independently of ust ?
Answer:
The reduced form equation for Pt is:
1
Pt = (β1 − α1 + udt − ust ).
α2 − β2
Pt is not independent of the disturbance term in either equation and so OLS would
yield inconsistent estimates. There is no instrument available, so both equations are
underidentified.
Provided that udt is not subject to autocorrelation, Pt−1 could be used as an
instrument in the demand equation. Provided that ust is not subject to
autocorrelation, OLS could be used to fit the second equation. It makes no
difference whether or not udt is distributed independently of ust .
The first equation could, alternatively, be fitted using OLS, with the variables
switched. From the second equation, Pt−1 determines Qt , and then, given Qt , the
demand equation determines Pt :
1
Pt = (Qt − β1 − udt ).
β2
The reciprocal of the slope coefficient provides a consistent estimator of β2 .

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International Programmes in Economics, Management, Finance, and the Social Sciences.

11. Models using time series data

11.24 Consider the following simple macroeconomic model:

Ct = β1 + β2 Yt + uCt
It = α1 + α2 (Yt − Yt−1 ) + uIt
Yt = Ct + It

where Ct , It , and Yt are aggregate consumption, investment, and income and uCt
and uIt are disturbance terms. The first relationship is a conventional consumption
function. The second relates investment to the change of output from the previous
year. (This is known as an ‘accelerator’ model.) The third is an income identity.
What can be said about the identification of the relationships in the model?
Answer:
The restriction on the coefficients of Yt and Yt−1 in the investment equation
complicates matters. A simple way of handling it is to define:

∆Yt = Yt − Yt−1

and to rewrite the investment equation as:

It = α1 + α2 ∆Yt + uIt .

We now have four endogenous variables and four equations, and one exogenous
variable. The consumption and investment equations are exactly identified. We
would fit them using Yt−1 as an instrument for Yt and ∆Yt , respectively. The other
two equations are identities and do not need to be fitted.

11.5 Answers to the additional exercises

A11.1 The linear regression indicates that expenditure on food increases by $0.032 billion
for every extra $ billion of disposable personal income (in other words, by 3.2 cents
out of the marginal dollar), that it increases by $0.403 billion for every point
increase in the price index, and that it increases by $0.001 billion for every
additional thousand population. The income coefficient is significant at the 1 per
cent level (ignoring problems to be discussed in Chapter 12). The positive price
coefficient makes no sense (remember that the dependent variable is measured in
real terms). The intercept has no plausible interpretation.
The logarithmic regression indicates that the income elasticity is 0.59 and highly
significant, and the price elasticity is −0.12, not significant. The negative elasticity
for population is not plausible. One would expect expenditure on food to increase
in line with population, controlling for other factors, and hence, as a first
approximation, the elasticity should be equal to 1. However, an increase in
population, keeping income constant, would lead to a reduction in income per
capita and hence to a negative income effect. Given that the income elasticity is
less than 1, one would still expect a positive elasticity overall for population. At
least the estimate is not significantly different from zero. In view of the high
correlation, 0.995, between LGDPI and LGPOP, the negative estimate may well be
a result of multicollinearity.

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International Programmes in Economics, Management, Finance, and the Social Sciences.

11.5. Answers to the additional exercises

A11.2

OLS logarithmic regressions

LGDPI LGP LGPOP R2
coef. s.e. coef. s.e. coef. s.e.
ADM −1.43 0.20 −0.28 0.10 6.88 0.61 0.975
BOOK −0.29 0.28 −1.18 0.21 4.94 0.82 0.977
BUSI 0.36 0.19 −0.11 0.27 2.79 0.51 0.993
CLOT 0.71 0.10 −0.70 0.05 0.15 0.36 0.998
DENT 1.23 0.14 −0.95 0.09 0.26 0.54 0.995
DOC 0.97 0.14 0.26 0.13 −0.27 0.52 0.993
FLOW 0.46 0.32 0.16 0.33 3.07 1.21 0.987
FOOD 0.59 0.08 −0.12 0.08 −0.29 0.26 0.992
FURN 0.36 0.28 −0.48 0.26 1.66 1.12 0.985
GAS 1.27 0.24 −0.24 0.06 −2.81 0.74 0.788
GASO 1.46 0.16 −0.10 0.04 −2.35 0.49 0.982
HOUS 0.91 0.08 −0.54 0.06 0.38 0.25 0.999
LEGL 1.17 0.16 −0.08 0.13 −1.50 0.54 0.976
MAGS 1.05 0.22 −0.73 0.44 −0.82 0.54 0.970
MASS −1.92 0.22 −0.57 0.14 6.14 0.65 0.785
OPHT 0.30 0.45 0.28 0.59 3.68 1.40 0.965
RELG 0.56 0.13 −0.99 0.23 2.72 0.41 0.996
TELE 0.91 0.13 −0.61 0.11 1.79 0.49 0.998
TOB 0.54 0.17 −0.42 0.04 −1.21 0.57 0.883
TOYS 0.59 0.10 −0.54 0.06 2.57 0.39 0.999

The price elasticities mostly lie in the range 0 to −1, as they should, and therefore
seem plausible. However the very high correlation between income and population,
0.995, has given rise to a problem of multicollinearity and as a consequence the
estimates of their elasticities are very erratic. Some of the income elasticities look
plausible, but that may be pure chance, for many are unrealistically high, or
negative when obviously they should be positive. The population elasticities are
even less convincing.

Correlations between prices, income and population

LGP, LGDPI LGP, LGPOP LGP, LGDPI LGP, LGPOP
ADM 0.61 0.61 GASO 0.05 0.03
BOOK 0.88 0.87 HOUS 0.49 0.55
BUSI 0.98 0.97 LEGL 0.99 0.99
CLOT −0.94 −0.96 MAGS 0.99 0.98
DENT 0.94 0.96 MASS 0.90 0.89
DOC 0.98 0.98 OPHT −0.68 −0.67
FLOW −0.93 −0.95 RELG 0.92 0.92
FOOD −0.60 −0.64 TELE −0.98 −0.99
FURN −0.95 −0.97 TOB 0.83 0.86
GAS 0.77 0.76 TOYS −0.97 −0.98

251
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International Programmes in Economics, Management, Finance, and the Social Sciences.

11. Models using time series data

A11.3 The regression indicates that the income elasticity is 0.40 and the price elasticity
0.21, the former very highly significant, the latter significant at the 1 per cent level
using a one-sided test. If the specification is:

FOOD DPI
log = β1 + β2 log + β3 log PRELFOOD + u
POP POP

it may be rewritten:

log FOOD = β1 + β2 log DPI + β3 log PRELFOOD + (1 − β2 ) log POP + u.

This is a restricted form of the specification in Exercise A11.2:

log FOOD = β1 + β2 log DPI + β3 log PRELFOOD + β4 log POP + u

with β4 = 1 − β2 . We can test the restriction by comparing RSS for the two
regressions:

(0.023232 − 0.016936)/1
F (1, 41) = = 15.24.
0.016936/41

The critical value of F (1, 40) at the 0.1 per cent level is 12.61. The critical value for
F (1, 41) must be slightly lower. Thus we reject the restriction. Since the restricted
version is misspecified, our interpretation of the coefficients of this regression and
the t tests are invalidated.

A11.4 Given that the critical values of F (1, 41) at the 5 and 1 per cent levels are 4.08 and
7.31 respectively, the results of the F test may be summarised as follows:

• Restriction not rejected: CLOT, DENT, DOC, FURN, HOUS.

• Restriction rejected at the 5 per cent level: MAGS.

• Restriction rejected at the 1 per cent level: ADM, BOOK, BUSI, FLOW,
FOOD, GAS, GASO, LEGL, MASS, OPHT, RELG, TELE, TOB, TOYS.

However, for reasons that will become apparent in the next chapter, these findings
must be regarded as provisional.

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International Programmes in Economics, Management, Finance, and the Social Sciences.

11.5. Answers to the additional exercises

Tests of a restriction
RSSU RSSR F t
ADM 0.125375 0.480709 116.20 10.78
BOOK 0.223664 0.461853 43.66 6.61
BUSI 0.084516 0.167580 40.30 6.35
CLOT 0.021326 0.021454 0.25 −0.50
DENT 0.033275 0.034481 1.49 1.22
DOC 0.068759 0.069726 0.58 −0.76
FLOW 0.220256 0.262910 7.94 2.82
FOOD 0.016936 0.023232 15.24 −3.90
FURN 0.157153 0.162677 1.44 1.20
GAS 0.185578 0.300890 25.48 −5.05
GASO 0.078334 0.139278 31.90 −5.65
HOUS 0.011270 0.012106 3.04 1.74
LEGL 0.082628 0.102698 9.96 −3.16
MAGS 0.096620 0.106906 4.36 −2.09
MASS 0.143775 0.330813 53.34 7.30
OPHT 0.663413 0.822672 9.84 3.14
RELG 0.053785 0.135532 62.32 7.89
TELE 0.054519 0.080728 19.71 4.44
TOB 0.062452 0.087652 16.54 −4.07
TOYS 0.031269 0.071656 52.96 7.28

A11.5 If the specification is:

FOOD DPI
log = β1 + β2 log + β3 log PRELFOOD + γ1 POP + u
POP POP
it may be rewritten:

log FOOD = β1 + β2 log DPI + β3 log PRELFOOD + (1 − β2 + γ1 ) log POP + u.

This is equivalent to the specification in Exercise A11.1:

log FOOD = β1 + β2 log DPI + β3 log PRELFOOD + β4 log POP + u

with β4 = 1 − β2 + γ1 . Note that this is not a restriction. (1) – (3) are just different
ways of writing the unrestricted model.
A t test of H0 : γ1 = 0 is equivalent to a t test of H0 : β4 = 1 − β2 , that is, that the
restriction in Exercise A11.3 is valid. The t statistic for LGPOP in the regression is
−3.90, and hence again we reject the restriction. Note that the test is equivalent to
the F test. −3.90 is the square root of 15.24, the F statistic, and it can be shown
that the critical value of t is the square root of the critical value of F .

A11.6 The t statistics for all the categories of expenditure are supplied in the table in the
answer to Exercise A11.4. Of course they are equal to the square root of the F
statistic, and their critical values are the square roots of the critical values of F , so
the conclusions are identical and, like those of the F test, should be treated as
provisional.

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International Programmes in Economics, Management, Finance, and the Social Sciences.

11. Models using time series data

A11.7 Show that β2 + β3 and (β4 + β5 ) are theoretically the long-run (equilibrium) income
and price elasticities.
In equilibrium, LGCAT = LGCAT, LGDPI = LGDPI (−1) = LGDPI and
LGPRCAT = LGPRCAT (−1) = LGPRCAT. Hence, ignoring the transient effect
of the disturbance term:
LGCAT = β1 + β2LGDPI + β3LGDPI + β4LGPRCAT + β5LGPRCAT
= β1 + (β2 + β3 )LGDPI + (β4 + β5 )LGPRCAT.
Thus the long-run equilibrium income and price elasticities are θ = β2 + β3 and
φ = β4 + β5 , respectively.
Reparameterise the model and fit it to obtain direct estimates of these long-run
elasticities and their standard errors.
We will reparameterise the model to obtain direct estimates of θ and φ and their
standard errors. Write β3 = θ − β2 and φ = β4 + β5 and substitute for β3 and β5 in
the model. We obtain:
LGCAT = β1 + β2 LGDPI + (θ − β2 )LGDPI (−1) + β4 LGPRCAT + (φ − β4 )LGPRCAT (−1) + u
= β1 + β2 (LGDPI − LGDPI (−1)) + θLGDPI (−1)
+β4 (LGPRCAT − LGPRCAT (−1)) + φLGPRCAT (−1) + u
= β1 + β2 DLGDPI + θLGDPI (−1) + β4 DLGPRCAT + φLGPRCAT (−1) + u

where DLGDPI = LGDPI − LGDPI (−1) and DLGPRCAT = LGPRCAT −

LGPRCAT (−1).
The output for HOUS is shown below. DLGPRCAT has been abbreviated as
DLGP.

============================================================
Dependent Variable: LGHOUS
Method: Least Squares
Sample(adjusted): 1960 2003
Included observations: 44 after adjusting endpoints
============================================================
Variable Coefficient Std. Error t-Statistic Prob.
============================================================
C 0.020785 0.144497 0.143844 0.8864
DLGDPI 0.329571 0.150397 2.191340 0.0345
LGDPI(-1) 1.013147 0.006815 148.6735 0.0000
DLGP -0.088813 0.165651 -0.536144 0.5949
LGPRHOUS(-1) -0.447176 0.035927 -12.44689 0.0000
============================================================
R-squared 0.999039 Mean dependent var 6.379059
Adjusted R-squared 0.998940 S.D. dependent var 0.421861
S.E. of regression 0.013735 Akaike info criter-5.631127
Sum squared resid 0.007357 Schwarz criterion -5.428379
Log likelihood 128.8848 F-statistic 10131.80
Durbin-Watson stat 0.536957 Prob(F-statistic) 0.000000
============================================================
Confirm that the estimates are equal to the sum of the individual shortrun
elasticities found in Exercise 11.9.
The estimates of the long-run income and price elasticities are 1.01 and −0.45,
respectively. The output below is for the model in its original form, where the

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International Programmes in Economics, Management, Finance, and the Social Sciences.

11.5. Answers to the additional exercises

coefficients are all short-run elasticities. It may be seen that, for both income and
price, the sum of the estimates of the shortrun elasticities is indeed equal to the
estimate of the long-run elasticity in the reparameterised specification.

============================================================
Dependent Variable: LGHOUS
Method: Least Squares
Sample(adjusted): 1960 2003
Included observations: 44 after adjusting endpoints
============================================================
Variable Coefficient Std. Error t-Statistic Prob.
============================================================
C 0.020785 0.144497 0.143844 0.8864
LGDPI 0.329571 0.150397 2.191340 0.0345
LGDPI(-1) 0.683575 0.147111 4.646648 0.0000
LGPRHOUS -0.088813 0.165651 -0.536144 0.5949
LGPRHOUS(-1) -0.358363 0.165782 -2.161660 0.0368
============================================================
R-squared 0.999039 Mean dependent var 6.379059
Adjusted R-squared 0.998940 S.D. dependent var 0.421861
S.E. of regression 0.013735 Akaike info criter-5.631127
Sum squared resid 0.007357 Schwarz criterion -5.428379
Log likelihood 128.8848 F-statistic 10131.80
Durbin-Watson stat 0.536957 Prob(F-statistic) 0.000000
============================================================
Compare the standard errors with those found in Exercise 11.9 and state your
conclusions.
The standard errors of the long-run elasticities in the reparameterised version are
much smaller than those of the short-run elasticities in the original specification,
and the t statistics accordingly much greater. Our conclusion is that it is possible
to obtain relatively precise estimates of the long-run impact of income and price,
even though multicollinearity prevents us from deriving precise short-run estimates.

A11.8 Show how this model may be derived from the demand function and the adaptive
expectations process.
The adaptive expectations process may be rewritten:

iet+1 = λit + (1 − λ)iet .

Substituting this into (1), one obtains:

Bt = β1 + β2 λit + β2 (1 − λ)iet + ut .

We note that if we lag (1) by one time period:

Bt−1 = β1 + β2 iet + ut−1 .

Hence:
β2 iet = Bt−1 − β1 − ut−1 .
Substituting this into the second equation above, one has:

Bt = β1 λ + β2 λit + (1 − λ)Bt−1 + ut − (1 − λ)ut−1 .

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International Programmes in Economics, Management, Finance, and the Social Sciences.

11. Models using time series data

This is equation (3) in the question, with γ1 = β1 λ, γ2 = β2 λ, γ3 = 1 − λ, and

vt = ut − (1 − λ)ut−1 .
Explain why inconsistent estimates of the parameters will be obtained if equation
(3) is fitted using ordinary least squares (OLS). (A mathematical proof is not
required. Do not attempt to derive expressions for the bias.)
In equation (3), the regressor Bt−1 is partly determined by ut−1 . The disturbance
term vt also has a component ut−1 . Hence the requirement that the regressors and
the disturbance term be distributed independently of each other is violated. The
violation will lead to inconsistent estimates because the regressor and the
disturbance term are contemporaneously correlated.
Describe a method for fitting the model that would yield consistent estimates.
If the first equation in this exercise is true for time period t + 1, it is true for time
period t:
iet = λit−1 + (1 − λ)iet−1 .
Substituting into the second equation in (a), we now have:

Bt = β1 + β2 λit + β2 λ(1 − λ)it−1 + (1 − λ)2 iet−1 + ut .

Continuing to lag and substitute, we have:

Bt = β1 + β2 λit + β2 λ(1 − λ)it−1 + · · · + β2 λ(1 − λ)s−1 it−s+1 + (1 − λ)s iet−s+1 + ut .

For s large enough, (1 − λ)s will be so small that we can drop the unobservable term
iet−s+1 with negligible omitted variable bias. The disturbance term is distributed
independently of the regressors and hence we obtain consistent estimates of the
parameters. The model should be fitted using a nonlinear estimation technique that
takes account of the restrictions implicit in the specification.
Suppose that ut were subject to the first-order autoregressive process:

ut = ρut−1 + εt

where εt is not subject to autocorrelation. How would this affect your answer to the
second part of this question?
vt is now given by:

vt = ut − (1 − λ)ut−1 = ρut−1 + εt − (1 − λ)ut−1 = εt − (1 − ρ − λ)ut−1 .

Since ρ and λ may reasonably be assumed to lie between 0 and 1, it is possible that
their sum is approximately equal to 1, in which case vt is approximately equal to
the innovation t . If this is the case, there would be no violation of the regression
assumption described in the second part of this question and one could use OLS to
fit (3) after all.
Suppose that the true relationship was actually:

Bt = β1 + β2 it + ut (1∗)

with ut not subject to autocorrelation, and the model is fitted by regressing Bt on it

and Bt−1 , as in equation (3), using OLS. How would this affect the regression
results?

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International Programmes in Economics, Management, Finance, and the Social Sciences.

11.5. Answers to the additional exercises

The estimators of the coefficients will be inefficient in that Bt−1 is a redundant

variable. The inclusion of Bt−1 will also give rise to finite sample bias that would
disappear in large samples.
How plausible do you think an adaptive expectations process is for modelling
expectations in a bond market?
The adaptive expectations model is implausible since the expectations process
would change as soon as those traders taking advantage of their knowledge of it
started earning profits.

A11.9 The regression indicates that the short-run income, price, and population
elasticities for expenditure on food are 0.14, −0.10, and −0.05, respectively, and
that the speed of adjustment is (1 − 0.73) = 0.27. Dividing by 0.27, the long-run
elasticities are 0.52, −0.37, and −0.19, respectively. The income and price
elasticities seem plausible. The negative population elasticity makes no sense, but it
is small and insignificant. The estimates of the short-run income and price
elasticities are likewise not significant, but this is not surprising given that the
point estimates are so small.

A11.10 The table gives the result of the specification with a lagged dependent variable for
all the categories of expenditure.

OLS logarithmic regression

LGDPI LGP LGPOP LGCAT (−1) Long-run effects
coef. s.e. coef. s.e. coef. s.e. coef. s.e. DPI P
ADM −0.38 0.18 −0.10 0.06 2.03 0.74 0.68 0.09 −1.18 −0.33
BOOK −0.36 0.20 −0.21 0.22 2.07 0.74 0.75 0.12 −1.46 −1.05
BUSI 0.10 0.13 0.03 0.18 0.78 0.45 0.72 0.11 0.33 0.09
CLOT 0.44 0.10 −0.40 0.07 0.01 0.32 0.43 0.09 0.77 −0.70
DENT 0.71 0.18 −0.46 0.16 −0.13 0.51 0.47 0.13 1.34 −0.87
DOC 0.23 0.14 −0.11 0.10 0.21 0.35 0.78 0.10 1.04 −0.52
FLOW 0.20 0.24 −0.31 0.27 0.07 0.98 0.75 0.11 0.81 −1.25
FOOD 0.14 0.09 −0.10 0.06 −0.05 0.19 0.73 0.11 0.53 −0.35
FURN 0.07 0.22 −0.07 0.22 0.82 0.91 0.68 0.12 0.21 −0.23
GAS 0.10 0.17 −0.06 0.03 −0.13 0.45 0.76 0.08 0.42 −0.26
GASO 0.32 0.11 −0.10 0.02 −0.59 0.25 0.80 0.06 1.56 −0.47
HOUS 0.30 0.05 −0.09 0.04 −0.13 0.10 0.73 0.05 1.11 −0.32
LEGL 0.40 0.14 0.10 0.09 −0.90 0.36 0.68 0.09 1.23 0.30
MAGS 0.57 0.21 −0.48 0.37 −0.56 0.44 0.55 0.12 1.27 −1.08
MASS −0.28 0.29 −0.23 0.11 1.08 0.89 0.75 0.12 −1.14 −0.93
OPHT 0.30 0.24 −0.28 0.33 −0.45 0.85 0.88 0.09 2.48 −2.25
RELG 0.34 0.09 −0.71 0.17 1.25 0.38 0.51 0.09 0.68 −1.44
TELE 0.15 0.14 0.00 0.12 0.68 0.37 0.81 0.12 0.77 0.02
TOB 0.12 0.14 −0.12 0.05 −0.31 0.43 0.71 0.11 0.43 −0.43
TOYS 0.31 0.11 −0.27 0.08 1.44 0.47 0.47 0.12 0.58 −0.51

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International Programmes in Economics, Management, Finance, and the Social Sciences.

11. Models using time series data

A11.11 In his classic study Distributed Lags and Investment Analysis (1954), Koyck
investigated the relationship between investment in railcars and the volume of
freight carried on the US railroads using data for the period 1884–1939. Assuming
that the desired stock of railcars in year t depended on the volume of freight in year
t − 1 and year t − 2 and a time trend, and assuming that investment in railcars was
subject to a partial adjustment process, he fitted the following regression equation
using OLS (standard errors and constant term not reported):

Ibt = 0.077Ft−1 + 0.017Ft−2 − 0.0033t − 0.110Kt−1 R2 = 0.85

where It = Kt − Kt−1 is investment in railcars in year t (thousands), Kt is the

stock of railcars at the end of year t (thousands), and Ft is the volume of freight
handled in year t (ton-miles).
Provide an interpretation of the equation and describe the dynamic process implied
by it. (Note: It is best to substitute Kt − Kt−1 for It in the regression and treat it as
a dynamic relationship determining Kt ).
Given the information in the question, the model may be written:

Kt∗ = β1 + β2 Ft−1 + β3 Ft−2 + β4 t + ut

Kt − Kt−1 = It = λ(Kt∗ − Kt−1 ).

Hence:
It = λβ1 + λβ2 Ft−1 + λβ3 Ft−2 + λβ4 t − λKt−1 + λut .
From the fitted equation:

λ
b = 0.110
0.077
βb2 = = 0.70
0.110
0.017
βb3 = = 0.15
0.110
−0.0033
βb4 = = −0.030.
0.110
Hence the short-run effect of an increase of 1 million ton-miles of freight is to
increase investment in railcars by 7,000 one year later and 1,500 two years later. It
does not make much sense to talk of a short-run effect of a time trend.
In the long-run equilibrium, neglecting the effects of the disturbance term, Kt and
Kt∗ are both equal to the equilibrium value K and Ft−1 and Ft−2 are both equal to
their equilibrium value F. Hence, using the first equation:

K = β1 + (β2 + β3 )F + β4 t.

Thus an increase of one million ton-miles of freight will increase the stock of
railcars by 940 and the time trend will be responsible for a secular decline of 33
railcars per year.

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International Programmes in Economics, Management, Finance, and the Social Sciences.

11.5. Answers to the additional exercises

A11.12 One researcher asserts that consistent estimates will be obtained if (2) is fitted
using OLS and (1) is fitted using IV, with Yt−1 as an instrument for Xt . Determine
whether this is true.
(2) may indeed be fitted using OLS. Strictly speaking, there may be an element of
bias in finite samples because of noncontemporaneous correlation between vt and
future values of Yt−1 .
We could indeed use Yt−1 as an instrument for Xt in (1) because Yt−1 is a
determinant of Xt but is not (contemporaneously) correlated with ut .
The other researcher asserts that consistent estimates will be obtained if both (1)
and (2) are fitted using OLS, and that the estimate of β2 will be more efficient than
that obtained using IV. Determine whether this is true.
This assertion is also correct. Xt is not correlated with ut , and OLS estimators are
more efficient than IV estimators when both are consistent. Strictly speaking, there
may be an element of bias in finite samples because of noncontemporaneous
correlation between ut and future values of Xt .

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© Christopher Dougherty, 2016. All rights reserved.
Published on the Online Resource Centre to accompany Dougherty: Introduction to Econometrics, 5th edition, by Oxford University Press.