I NTRODUCTION TO E CONOMETRICS II:

M ACROECONOMETRICS
Vasco M Carvalho
University of Cambridge
1/8 Lectures

February 17, 2015

M ACROECONOMETRICS

Distinctive features
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focus on relationships representing behaviour of economic

aggregates (consumption, production, prices, labour markets)
analyses time series data with no cross-section information
data is typically correlated over time
need not have a causal interpretation

Textbook references:
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will refer to S&W: J. Stock and M. Watson, Introduction to

Econometrics (main reference; but will deviate)
J. Wooldridge, Introductory Econometrics and R.L. Thomas,
Modern Econometrics: An Introduction (other good references)

M ACRO T IME S ERIES

U K R ealG D P 60Q 1 -13Q 4
2,400

2,000

1,600

1,200

800

400
60

65

70

75

80

85

90

95

00

05

10

Most series contain trends )Time varying mean

)Non-stationarity

M ACRO T IME S ERIES

U K InterestR ate 75Q 1 -13Q 4
20

16

12

0
1975

1980

1985

1990

1995

2000

2005

2010

Macro series are usually persistent )Observations are

correlated through time)Not i.i.d. random sampling as in
cross-section

M ACRO T IME S ERIES

U K Inflation -U nem ploym ent72-12
25

20

15

10

-5
1975

1980

1985

1990

1995

IN FLATIO N

2000

2005

2010

Macro series typically comove )Exploit information in series

x to understand y )Model joint dynamics of series

A IMS FOR A GIVEN SAMPLE

Description
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Explanation
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Estimated parameters need not have an economic

interpretation

Extend description by dening the model in terms of (some)

economic theory giving interpretation to parameters

Theory testing
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Theory imposes restrictions on parameter values which are

tested in-sample

A IMS FOR PREDICTION

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Uses econometric model based on specic sample to make

inferences about how the variable concerned will behave
out-of-sample

Forecasting
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Scenario analysis
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Typically involves a conditional forecast - some value must be

assumed for exogenous variable

Comparison of forecasts based on alternative assumptions

about exogenous variable

Policy analysis
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Scenario analysis to the case where exogenous variable is a

policy instrument

A UTOREGRESSION

Natural/Simplest starting point for a time series model is to

use past values of y (i.e. yt 1 , yt 2 , ...) to understand yt

An Autoregression is a regression in which yt is regressed

against its own lagged values

The number of lags used as regressors is called the order of

the autoregression
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In a First Order Autoregression - AR(1) - yt is regressed

against yt 1
In a p th Order Autogression - AR(p) - yt is regressed against a
set of regressors (yt 1 , yt 2 , ..., yt p )

A UTOREGRESSION : AR(1)
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Population AR(1) model is

yt = 0 + 1 yt

)can use t statistics to test 1 = 0 vs 1 6= 0

Note:
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yt is stationary: its probability distribution does not change

over time
E (ut jyt 1 ) = 0 : disturbances are uncorrelated with regressors

Under these conditions OLS is asymptotically unbiased consistent - and asymptotically normally distributed
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+ ut

The AR(1) model can be estimated by OLS of yt on yt

under the assumptions:
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0 and 1 do not have causal interpretations (simply a

correlation)
AR(1) is a rst order stochastic dierence equation

A UTOREGRESSION : AR( P )
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Population AR(p) model is

yt = 0 + 1 yt

+ ... + p yt

+ ut
1

yt is stationary
E (ut jyt 1 , yt 2 , ..., yt p ) = 0

Under these conditions OLS is asymptotically unbiased consistent - and asymptotically normally distributed
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+ 2 yt

The AR(p) model can be estimated by OLS of yt on yt

under the assumptions:
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)can use t statistics for individual coe cients and F tests

to test joint signicance

Notes:
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no causal interpretation
AR(1) is special case
methods to determine order p ! more on this later

A UTOREGRESSIVE D ISTRIBUTED L AG M ODEL : ADL

MODEL
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Autoregressive models use only past values of variables

Makes sense to add other variables (x ) that might be useful in
understanding dynamics of y , above and beyond the lagged
values of y :
yt = 0 + 1 yt

+ 1 xt + 2 xt

+ ut

This is an Autoregressive Distributed Lag (ADL) model (S&W

14.1-14.4)
I xt + x
1
2 t 1 : Distributed lag in the time series xt
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1 yt 1 : Autoregressive in the time series yt

Since both contain one lag equation above is ADL(1,1)
Generalization to longer lags and other explanatory variables is
straightforward [ADL(p,q)]

Underlying assumption justifying OLS for ADL:

E (ut jyt

1 , yt 2 , ..., yt p , xt , xt 1 )

=0

L AG O PERATORS
A N A LTERNATIVE N OTATION
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ADL and AR models are often written using lag operator

notation- useful for following literature

Dene function L(yt ) which operates on a time series with the

property
L(yt ) = yt 1

Such that:
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L(yt ) = L(yt ) = yt 1
L(xt + yt ) = L(xt ) + L(yt ) = xt 1 + yt 1
L(L(yt )) = L(yt 1 ) = yt 2 = L2 (yt )
L0 (yt ) = 1yt = yt
L(constant ) = constant

Note: L() function is linear so it is usually written without the

brackets
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e.g. Lyt = yt 1 ; L2 yt = yt 2 ...

L AG O PERATORS
A N A LTERNATIVE N OTATION

To see lag operators at work take ADL(1,1) model

yt
yt

(1
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1 L)yt

= 0 + 1 yt 1 + 1 xt + 2 xt 1 + ut
= 0 + 1 Lyt + 1 xt + 2 Lxt + ut
= 0 + (1 + 2 L) + ut

(1 1 L) and (1 + 2 L) are called lagged polynomials

Higher order ADL(p,q) models can still be represented by
(higher-order) lagged polynomials
AR(p) models: ditto

S HOCKS , RESPONSES AND MULTIPLIERS

T RANSITORY SHOCKS
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Take ADL(1,1) model

yt = 0 + 1 yt

+ 1 xt + 2 xt

+ ut

What is the impact of a one-o, transitory, marginal change in

xt on yt ?
yt
= 1
xt

This is an impact or short-run multiplier

But, this one-o change has dynamic eects on yt through

time
yt +1 = 0 + 1 yt + 1 xt +1 + 2 xt + ut +1

yt +1
yt
xt
= 1
+ 2
= 1 1 + 2
xt
xt
xt

S HOCKS , RESPONSES AND MULTIPLIERS

T RANSITORY SHOCKS
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But, this one-o change has dynamic eects on yt through

time
yt +2 = 0 + 1 yt +1 + 1 xt +2 + 2 xt +1 + ut +2

yt +2
yt +1
= 1
= 1 ( 1 1 + 2 )
xt
xt

...
yt +p
)
= p1
xt
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( 1 1 + 2 ) = p1 1 + p1

As long as j 1 j < 1 eects of transitory shocks of xt die out

Same is true if you were to consider impact of a marginal
change in yt 1
j 1 j < 1: implies stability )transitory shocks do not have
long run eects on y series

S HOCKS , RESPONSES AND MULTIPLIERS

P ERMANENT SHOCKS
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What about permanent changes in xt ? What is the long-run

eect on y of a sustained shock to x ?

We can analyse this by looking at the steady-state path

dened as:
xt
yt
ut

= xt
= yt
= ut

= ... = xt
1 = ... = yt
1 = ... = ut

= xE
E
n =y
n =0

i.e. "long-run equilibrium" path of y assuming x has been

unchanged for many periods at its own equilibrium value x E
and there are no disturbances

At this equilibrium our ADL(1,1) example implies

y E = 0 + 1 y E + 1 x E + 2 x E

S HOCKS , RESPONSES AND MULTIPLIERS

P ERMANENT SHOCKS
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At this equilibrium our ADL(1,1) example implies

y E = 0 + 1 y E + 1 x E + 2 x E

Now suppose x E rises permanently. We want to know new

equilibrium time path for y :
yE

(1

1 )y E
yE
y E
x E

= 0 + 1 y E + 1 x E + 2 x E
= 0 + ( 1 + 2 )x E
0
( 1 + 2 ) E
=
+
x
(1 1 )
(1 1 )
( 1 + 2 )
=
(1 1 )

This is the long-run eect of a permanent change of x E

For models with longer lags it can be shown that

y E
x E

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1 j j