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Introduction To VAR Model

The document provides an introduction to vector autoregressive (VAR) models. It explains that a VAR model relates current observations of a variable to past observations of itself and other variables in the system, allowing for feedback between variables. The document outlines the basics of VAR models, including their uses in economics and other fields, the three main types of VAR models, specifying and estimating VAR models, and using VAR models for forecasting and structural analysis.

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205 views8 pages

Introduction To VAR Model

The document provides an introduction to vector autoregressive (VAR) models. It explains that a VAR model relates current observations of a variable to past observations of itself and other variables in the system, allowing for feedback between variables. The document outlines the basics of VAR models, including their uses in economics and other fields, the three main types of VAR models, specifying and estimating VAR models, and using VAR models for forecasting and structural analysis.

Uploaded by

ibsa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Introduction to VAR Model

In today's blog, you'll learn the basics of the vector autoregressive model.
We lay the foundation for getting started with this crucial multivariate time
series model and cover the important details including:

 What a VAR model is.


 Who uses VAR models.
 Basic types of VAR models.
 How to specify a VAR model.
 Estimation and forecasting with VAR models.

What is a vector autoregressive model?


The vector autoregressive (VAR) model is a workhouse multivariate time
series model that relates current observations of a variable with past
observations of itself and past observations of other variables in the
system.

VAR models differ from univariate autoregressive models because they


allow feedback to occur between the variables in the model. For example,
we could use a VAR model to show how real GDP is a function of policy
rate and how policy rate is, in turn, a function of real GDP.

Advantages of VAR models

✔ A systematic but flexible approach for capturing complex real-


world behavior.
✔ Better forecasting performance.
✔ Ability to capture the intertwined dynamics of time series data.

VAR modeling is a multi-step process and a complete VAR analysis


involves:

1. Specifying and estimating a VAR model.


2. Using inferences to check and revise the model (as needed).
3. Forecasting.
4. Structural analysis.
Who uses VAR models?
VAR models are traditionally widely used in finance and econometrics
because they offer a framework for accomplishing important modeling
goals, including (Stock and Watson 2001):

 Data description.
 Forecasting.
 Structural inference.
 Policy analysis.

However, more recently VAR models have been gaining traction in other
fields like epidemiology, medicine, and biology.

The reduced form, recursive, and structural


VAR
There are three broad types of VAR models, the reduced form, the
recursive form, and the structural VAR model.

Reduced form VAR models consider each variable to be a function of:

 Its own past values.


 The past values of other variables in the model.

While reduced form models are the simplest of the VAR models, they do
come with disadvantages:

 Contemporaneous variables are not related to one another.


 The error terms will be correlated across equations. This means we
cannot consider what impacts individual shocks will have on the
system.

Recursive VAR models contain all the components of the reduced form


model, but also allow some variables to be functions of other concurrent
variables. By imposing these short-run relationships, the recursive model
allows us to model structural shocks.

Structural VAR models include restrictions that allow us to identify causal


relationships beyond those that can be identified with reduced form or
recursive models. These causal relationships can be used to model and
forecast impacts of individual shocks, such as policy decisions
A simple example
As an example, let's consider a VAR with three endogenous variables, the
unemployment rate, the inflation rate, and interest rates.

A reduced form VAR(2) model of the system includes the following


equations:

To estimate the structural VAR model of the system, we have to put


restrictions on our model. For example, we may assume that the Fed
follows the inflation targeting rule for setting interest rates. This assumption
would be built into our system as the equation for interest rates.

Specifying a VAR model


What makes up a VAR model?
A VAR model is made up of a system of equations that represents the
relationships between multiple variables. When referring to VAR models,
we often use special language to specify:

 How many endogenous variables there are included.


 How many autoregressive terms are included.

For example, if we have two endogenous variables and autoregressive


terms, we say the model is a Bivariate VAR(2) model. If we have three
endogenous variables and four autoregressive terms, we say the model is
a Trivariate VAR(4) model.

In general, a VAR model is composed of n-


equations (representing n endogenous variables) and includes p-lags of the
variables.

How do we choose the number of lags in a VAR model?


Lag selection is one of the important aspects of VAR model specification. In
practical applications, we generally choose a maximum number of lags,
$p_{max}$, and evaluate the performance of the model including $p = 0,
1, \ldots, p_{max}$.

The optimal model is then the model VAR(p) which minimizes some lag
selection criteria. The most commonly used lag selection criteria are:

 Akaike (AIC)
 Schwarz-Bayesian (BIC)
 Hannan-Quinn (HQ).

These methods are usually built into software and lag selection is almost
completely automated now.

How do we decide what endogenous variables to


include in our VAR model?
From an estimation standpoint, it is important to be deliberate about how
many variables we include in our VAR model. Adding additional variables:

 Increases the number of coefficients to be estimated for each


equation and each number of lags.
 Introduce additional estimation error.
Deciding what variables to include in a VAR model should be founded in
theory, as much as possible. We can use additional tools, like Granger
causality or Sims causality, to test the forecasting relevance of variables.

Granger causality tests whether a variable is “helpful” for forecasting the


behavior of another variable. It’s important to note that Granger causality
only allows us to make inferences about forecasting capabilities -- not
about true causality.

Estimating and inference in VAR models


Despite their seeming complexities, VAR models are quite easy to
estimate. The equation can be estimated using ordinary least squares
given a few assumptions:

 The error term has a conditional mean of zero.


 The variables in the model are stationary.
 Large outliers are unlikely.
 No perfect multicollinearity.

Under these assumptions, the ordinary least squares estimates:

 Will be consistent.
 Can be evaluated using traditional t-statistics and p-values.
 Can be used to jointly test restrictions across multiple equations.

Forecasting
One of the most important functions of VAR models is to generate
forecasts. Forecasts are generated for VAR models using an iterative
forecasting algorithm:

1. Estimate the VAR model using OLS for each equation.


2. Compute the one-period-ahead forecast for all variables.
3. Compute the two-period-ahead forecasts, using the one-period-
ahead forecast.
4. Iterate until the h-step ahead forecasts are computed.

Reporting and evaluating VAR models


Often we are more interested in the dynamics that are predicted by our
VAR models than the actual coefficients that are estimated. For this
reason, it is most common that VAR studies report:

 Granger-causality statistics.
 Impulse response functions.
 Forecast error decompositions

Granger-causality statistics
As we previously discussed, Granger-causality statistics test whether one
variable is statistically significant when predicting another variable.

The Granger-causality statistics are F-statistics that test if the coefficients


of all lags of a variable are jointly equal to zero in the equation for another
variable. As the p-value of the F-statistic decreases, evidence that a
variable is relevant for predict another variable increases.

For example, in the Granger-causality test of $X$ on $Y$, if the p-value is


0.02 we would say that $X$ does help predict $Y$ at the 5% level.
However, if the p-value is 0.3 we would say that there is no evidence that
$X$ helps predict $Y$.

Impulse response functions


Forecast error decomposition separates the forecast error variance into proportions
attributed to each variable in the model.

Intuitively, this measure helps us judge how much of an impact one variable has on
another variable in the VAR model and how intertwined our variables' dynamics are.

For example, if X is responsible for 85% of the forecast error variance of Y, it is
explaining a large amount of the forecast variation in X. However, if X is only
responsible for 20% of the forecast error variance of Y, much of the forecast error
variance of Y is left unexplained by X.

Conclusion
VAR models are an essential component of multivariate time series modeling. After
today's blog, you should have a better understanding of the fundamentals of the VAR
model including:

 What a VAR model is.


 Who uses VAR models.
 Basic types of VAR models.
 How to specify a VAR model.
 Estimation and forecasting with VAR models.

Further Reading
1. Introduction to the Fundamentals of Time Series Data and Analysis
2. The Intuition Behind Impulse Response Functions and Forecast Error
Variance Decomposition
3. Introduction to Granger Causality

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