Christopher Dougherty EC220 - Introduction to econometrics (chapter 12) Slideshow: consequences of...

Christopher Dougherty

EC220 - Introduction to econometrics (chapter 12)Slideshow: consequences of autocorrelation

Original citation:

Dougherty, C. (2012) EC220 - Introduction to econometrics (chapter 12). [Teaching Resource]

© 2012 The Author

This version available at: http://learningresources.lse.ac.uk/138/

Available in LSE Learning Resources Online: May 2012

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CONSEQUENCES OF AUTOCORRELATION

1

The consequences of autocorrelation for OLS are similar to those of heteroscedasticity. In general, the regression coefficients remain unbiased, but OLS is inefficient because one can find an alternative regression technique that yields estimators with smaller variances.

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The other main consequence is that autocorrelation causes the standard errors to be estimated wrongly, often being biased downwards. Finally, although in general OLS estimates are unbiased, there is an important special case where they are biased.

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Unbiasedness is easily demonstrated, provided that Assumption C.7 is satisfied. In the case of the simple regression model shown, we have seen that the OLS estimator of the slope coefficient can be decomposed as the second line where the at are as defined in the third line.

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Now, if Assumption C.7 is satisfied, at and ut are distributed independently and we can write the expectation of b2 as shown. At no point have we made any assumption concerning whether ut is, or is not, subject to autocorrelation.

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5

All that we now require is E(ut) = 0 and this is easily demonstrated.

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6

For example, in the case of AR(1) autocorrelation, lagging the process one time period, we have the second line. Substituting for ut–1 in the first equation, we obtain the third.

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7

Continuing to lag and substitute, we can express ut in terms of current and lagged values of t with diminishing weights. Since, by definition, the expected value of each innovation is zero, the expected value of ut is zero.

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For higher order AR autocorrelation, the demonstration is essentially similar. For moving average autocorrelation, the result is immediate.

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9

For multiple regression analysis, the demonstration is the same, except that at is replaced by at*,

where at* depends on all of the observations on all of the explanatory variables in the model.

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We will not pursue analytically the other consequences of autocorrelation. Suffice to mention that the proof of the Gauss–Markov theorem, which guarantees the efficiency of the OLS estimators, does require no autocorrelation, as do the expressions for the standard errors.

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Now we come to the special case where OLS yields inconsistent estimators if the disturbance term is subject to autocorrelation.

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If the model specification includes a lagged dependent variable, OLS estimators are biased and inconsistent if the disturbance term is subject to autocorrelation. This will be demonstrated for AR(1) autocorrelation and an ADL(1,0) model with one X variable.

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13

Lagging the ADL(1,0) model by one time period, we obtain the third line. Thus Yt–1 depends on ut–1. As a consequence of the AR(1) autocorrelation ut also depends on ut–1.

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14

Hence we have a violation of part (1) of Assumption C.7. The explanatory variables, Yt–1, is not distributed independently of the disturbance term. As a consequence, OLS will yield inconsistent estimates.

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15

This was described as a special case, but actually it is an important one. ADL models are frequently used in time series regressions and autocorrelation is a common problem.

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Copyright Christopher Dougherty 2011.

These slideshows may be downloaded by anyone, anywhere for personal use.

Subject to respect for copyright and, where appropriate, attribution, they may be

used as a resource for teaching an econometrics course. There is no need to

refer to the author.

The content of this slideshow comes from Section 12.1 of C. Dougherty,

Introduction to Econometrics, fourth edition 2011, Oxford University Press.

Additional (free) resources for both students and instructors may be

downloaded from the OUP Online Resource Centre

http://www.oup.com/uk/orc/bin/9780199567089/.

Individuals studying econometrics on their own and who feel that they might

benefit from participation in a formal course should consider the London School

of Economics summer school course

EC212 Introduction to Econometrics

http://www2.lse.ac.uk/study/summerSchools/summerSchool/Home.aspx

or the University of London International Programmes distance learning course

20 Elements of Econometrics

www.londoninternational.ac.uk/lse.

11.07.25

Christopher Dougherty EC220 - Introduction to econometrics (chapter 12) Slideshow: consequences of...

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