[ ECO105 ] Econometrics

Violation of OLS classical assumptions: autocorrelation, heteroscedasticity, normality

Introduction

Time-series data, compared to cross-sectional, has additional assumption: no autocorrelation in residuals.

Dataset

Time-series dataset covers years of 1960 - 1999. In the file chicken.xls the following variables are given:

Ct – per capita chicken consumption (in pounds);

Pt – the price of chicken (in cents per pound);
PBt – the price of beef (in cents per pound);
Rt – interest rate (in percent) and
YDt – the U.S. per capita disposable income (in hundreds of dollars).

1. Test for heteroskedasticity (H0: residuals are homoscedastic)

White’s test is the most general heteroskedasticity test and is often used in empirical literature. It tests if the
variance in the error term is constant. Run the regression as usual assuming that we wish to explain per
capita chicken consumption Ct with the set of explanatory variables:

Standing on the OLS estimation output use Gretl function: Tests \ Heteroskedasticity \ White’s
test. The auxiliary test regression:

with
is going to be estimated to test:
H0: β1 = ... = β9 = 0 (homoskedasticity = constant variance) against
HA: at least one of βi ≠ 0 for i =1,..,9 (heteroskedasticity = not constant variance)

Test the null hypothesis of homoskedasticity against the alternative of heteroskedasticity in residuals
at 5% significance level. Use p-value of Chi-square statistics for hypothesis testing and conclude.

2. Tests for serial correlation (H0: residuals are not autocorrelated)

a) Plot residuals on a graph. Try to tell from the graph if there are signs of autocorrelation in residuals. This
might be done by running a usual regression. Save the residuals of the model by using Gretl function: Save
\ Residuals. Open the variable of your saved residuals and press on the Graph button on the top of the
values of residuals.

b) Run Durbin Watson (DW) first order autocorrelation test and conclude if there is autocorrelation in the
error term. Use DW test statistics to test one sided hypothesis if the first order autocorrelation persists. Use
5% significance level. It can be found in regression output in ‘Durbin-Watson’ line.

The test regression is given by the process of:

and hypothesis testing for one sided hypothesis is formulated as follows:

H0: p = 0 (no first-order serial correlation/autocorrelation) against
HA: p > 0 (serial first-order positive correlation)

As one-sided hypothesis at 5% significance level is going to be tested, use DW critical values (page 617 in
the textbook, or „Appendix A“ here) for hypothesis testing. For this particular model use critical values for
N = 40 (number of observations) and K = 3 (number of explanatory variables excluding the constant)

The decision rule is:

if d < dL then reject H0
if d > dU then do not reject H0
if dL < d < dU the conclusion cannot made

c) Run the more general Breusch-Godfrey test for autocorrelation to conclude if autocorrelation persists in
the error term. Test on 5% significance level, use p-value of F-statistics for hypothesis testing and conclude.
Standing on the estimated regression output use Gretl function:
Tests \ Autocorrelation \ Choose the lag order for tests - Start arbitrarily by including 4 lags
\ OK. The auxiliary test regression
̂= + + + + ̂− + ̂− + ̂− + ̂− +

is going to be estimated to test:

H0: 4 = 5 = 6 = 7 = 0(no serial correlation) against

HA: at least one of ≠ 0 0 for i = 4,..,7 (serial correlation in residuals).

If the lags of the higher order turn out to be insignificant (insignificance is tested with p-value of the necessary
coefficients; alternatively t-ratio of these coefficients), remove these one by one from the auxiliary regression.

3. Heteroskedasticity-and-autocorrelation consistent (HAC) standard errors

HAC standard errors take into account the presence of heteroskedasticity and/or autocorrelation in the
model, thus making the hypothesis testing for single parameters (i.e. t-values and consequently p-values of
t-statistics) as well as the group of parameters (i.e. F-statistics and consequently p-values of F- statistics)
more reliable.

Run the regression

by marking: Robust Standard Errors \ Press OK. Obtain output produced by Gretl and compare standard
errors and t-values with identical values of the initial model.

4. Normality test (H0: residuals are normally distributed)

Use Jacque – Berra test to evaluate if the error term of the model is normally distributed. Standing on
the saved residuals of the model use Gretl function: Variable \ Normality tests.

Obtain the table with Normality test results. Use p-value of JB statistics for hypothesis testing and
conclude if the error term is normally distributed.
The hypothesis testing is formed as follows:

H0: the error term is normally distributed

HA: otherwise

5. Test for multicollinearity (variance inflation factors)

If two or more explanatory variables are highly dependent on each other, it might cause problems in
estimating the model (often programs are unable to estimate such a model at all). Check therefore for the
presence of multicollinearity between explanatory variables. Mark all the explanatory variables,
press the right mouse button and use Gretl function Correlation matrix.

Collinearity (or multicollinearity) – the undesirable situation in multiple regression when a pair or several
independent (right hand side) variables are highly correlated. Variance inflation factors (VIF) – quantifies
the severity of multicollinearity in an ordinary least squares regression analysis. In GRETL it can be
simply found by clicking the right mouse button on the selected variables and choosing Collinearity. VIF
measures how much the variance of the estimated coefficients is increased over the case of no
correlation among right hand side variables. If no two variables are correlated, then all the VIFs will be 1,
while it is recommended that variables, having VIF above 10, should be removed from the model to
avoid consequences of multicollinearity. Transformation of variables or first differences could be
considered to alleviate the situation without the need of dropping a variable.

Appendix A. Table of Durbin-Watson critical values