Lags and Lag Structure

Distributed Lag Modeling

Introduction
We are often interested in variables that change
across time rather than across individuals.

Simple Static models relate a time series variable
to other time series variables.

The effect is assumed to operate within the
period.
Dynamic Models
Dynamic effects

Policy takes time to have an effect.
Size and nature of effect can vary over time.
Permanent vs. Temporary effects.

The Principle

Macroeconomics
e.g. the effect of X on Y in short run vs. the long run






impulse response function
X increases by 1 in year 1
returns to normal afterwards
what happens to y over time?


time
Y
Distributed Lag
Effect is distributed through time
consumption function: effect of income through time
effect of income taxes on GDP happens with a lag
effect of monetary policy on output through time
y
t
= o + |
0
x
t
+ |
1
x
t-1
+ |
2
x
t-2
+ e
t
i t
t
i
x
y E

=
o
o
|
) (
The Distributed Lag Effect
Economic action
at time t
Effect
at time t
Effect
at time t+1
Effect
at time t+2
The Distributed Lag Effect
Effect at time t
Economic action
at time t
Economic action
at time t-1
Economic action
at time t-2
Two Questions

1. How far back?
- What is the length of the lag?
- finite or infinite

2. Should the coefficients be restricted?
- e.g. smooth adjustment
- let the data decide
Unrestricted Finite DL
Finite: change in variable has an effect on another only for
a fixed period
Fare Price Changes affect Ridership for 6 months
the interval is assumed known with certainty

Unrestricted (unstructured)
the effect in period t+1 is not related to the effect in period t
y
t
= o + |
0
x
t
+ |
1
x
t-1
+ |
2
x
t-2
+ . . . + |
n
x
t-n
+ e
t
n unstructured lags
no systematic structure imposed on the |s
the |s are unrestricted
OLS will work
produce consistent and unbiased estimates
Problems
1. n observations are lost with n-lag setup.
data from 1990, 5 lags in model implies earliest point in regression is 1995
use up degrees of freedom (n-k)

2. high degree of multicollinearity among x
t-j
s
x
t
is very similar to x
t-1
--- little independent information

imprecise estimates
large std errors, low t-tests
hypothesis tests uncertain.

3. Several LHS variables
many degrees of freedom used for large n.

4. Could get greater precision using structure


Arithmetic Lag Structure
i
|
i
|
0
= (n+1)
|
1
= n
|
2
= (n-1)
|
n
=
.
.
.
0 1 2 . . . . . n n+1
.
.
.
.
linear
lag
structure
1. effect of X eventually goes to zero

2. Effect of each lag will be less than previous of
The Arithmetic Lag Structure
Imposing the relationship:
|
ii
= (n - i+ 1)
|
0
= (n+1)
|
1
= n
|
2
= (n-1)
|
3
= (n-2)
.
.
|
n-2
= 3
|
n-1
= 2
|
n
=
only need to estimate one coefficient, ,
instead of n+1 coefficients, |
0
, ... , |
n
.
y
t
= o + |
0
x
t
+ |
1
x
t-1
+ |
2
x
t-2
+ . . . + |
n
x
t-n
+ e
t
Suppose that X is (log of) fare price and Y is (log of)
Ridership, n=12 and is estimated to be 0.1
the effect of a change in x on Ridership in the current
period is |
0
=(n+1)=1.3
the impact of fare price changes one period later has
declined to |
1
=n=1.2
n periods later, the impact is |
n
= =0.1
n+1 periods later the impact is zero
i t
t
i
x
y E

=
o
o
|
) (
Estimation

Estimate using OLS
only need to estimate one parameter:
Have to do some algebra to rewrite the model in
form that can be estimated.
Advantages/disadvantages
Fewer parameters to be estimated (only one) than
in the unrestricted lag structure
Lower standard errors
Higher t-statistics
More reliable hypothesis tests
What if the restriction is untrue?
Biased and inconsistent
A bit like wrong exclusion restrictions in 2SLS
Is the linear restriction likely to be true?
Look at unrestricted model
Do f-test
2
1
/
/ ) (
df SSE
df SSE SSE
F
U
U R

=
F-test
estimate the unrestricted model
estimate the restricted (arithmetic lag) model
calculate the test statistic

compare with critical value F(df1,df2)
df1=n the number of restrictions
number of betas less number of gammas = (n+1)-1
df2=number of observations-number of variables in the
unrestricted model (incl. constant)
df2=(T-n)-(n+2)



Polynomial Distributed Lag
Linear shape of lags maybe restrictive
Want hump shape
Polynomial --- quadratic or higher

|
i
=
0
+
1
i +
2
i
2
i
i t
t
x
y E
|
o
o
=

) (
Polynomial Lag Structure
.
.
.
.
.
0 1 2 3 4
i
|
i
|
0
|
1
|
2
|
3
|
4
Similar idea to Arithmetic DL model; different shape to lags
Still Finite: the effect of X eventually goes to zero
The coefficients are related to each other
the effect of each lag will not necessarily be less than previous one i.e.
not uniform decline
Estimation
Estimate using OLS
only need to estimate p parameters:
number of parameters is equal to degree of polynomial
Have to do some algebra to rewrite the model in
form that can be estimated.
model reduces to arithmetic model if polynomial is of
degree 1
Do OLS on transformed model
Advantages/Disadvantages
Fewer parameters to be estimated (only the degree of
polynomial) than in the unrestricted lag structure
more precise
What if the restriction is untrue?
biased and inconsistent
Is the polynomial restriction likely to be true?
more flexible than arithmetic DL
what if approximately true?
Lag Length
For all three finite models we need to choose the lag length
(DL,ADL,PDL)
Think of this as choosing the cut-off point
The time beyond which a variable will cease to have an impact
No satisfactory objective criterion for deciding this
Choose n to be infinite?
Lag-Length Criteria
Akaikes AIC criterion



Schwarzs SC criterion




For each of these measures we seek that lag length that minimizes the
criterion used. Since adding more lagged variables reduces SSE, the
second part of each of the criteria is a penalty function for adding
additional lags.
2( 2)
ln
n
SSE n
AIC
T N T N
+
= +

( )
2 ln( )
( ) ln
n
n T N
SSE
SC n
T N T N
+
= +

Key Points
1. How far back?
- What is the length of the lag?
- No conclusive answer

2. Should the coefficients be restricted?
- Let the data decide: unrestricted
- Arithmetic or polynomial
- What degree of polynomial
Geometric Lag Model
DL is infinite --- infinite lag length
But cannot estimate an infinite number of parameters
restrict the lag coefficients to follow a pattern
estimate the parameters of this pattern
For the geometric lag the pattern is one of continuous
decline at decreasing rate

Geometric Lag Structure

|
i
.
.
.
.
.
0 1 2 3 4 i
|
1
= | |
|
2
= | |
2
|
3
= | |
3
|
4
= | |
4
|
0
= |
geometrically
declining
weights
Estimation
Cannot Estimate using OLS
OLS will be inconsistent (just as with simultaneous equations)
Only need to estimate two parameters: |,|
Have to do some algebra to rewrite the model in form that
can be estimated.
Then apply Koyck transformation
Then use 2SLS