Basic Regression Analysis

with Time Series Data

Chapter 10

Wooldridge: Introductory Econometrics:

A Modern Approach, 5e

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 Analyzing Time Series:
Basic Regression Analysis
The nature of time series data
Temporal ordering of observations; may not be arbitrarily reordered
Typical features: serial correlation/nonindependence of observations
How should we think about the randomness in time series data?
• The outcome of economic variables (e.g. GNP, Dow Jones) is
uncertain; they should therefore be modeled as random
variables
• Time series are sequences of r.v. (= stochastic processes)
• Randomness does not come from sampling from a population
• „Sample“ = the one realized path of the time series out of the
many possible paths the stochastic process could have taken

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 Analyzing Time Series:
Basic Regression Analysis
Example 10.2 on page 352

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 Analyzing Time Series:
Basic Regression Analysis
Example: US inflation and unemployment rates 1948-2003

Here, there are only two time series. There

may be many more variables whose paths
over time are observed simultaneously.

Time series analysis focuses on modeling

the dependency of a variable on its own
past, and on the present and past values
of other variables.

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 Analyzing Time Series:
Basic Regression Analysis
Examples of time series regression models
Static models
In static time series models, the current value of one variable
is modeled as the result of the current values of explanatory
variables
There is a contemporaneous relationship
between unemployment and inflation (=
Examples for static models Phillips-Curve).

The current murderrate is determined by the current conviction rate,

unemployment rate, and fraction of young males in the population.

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 Analyzing Time Series:
Basic Regression Analysis
Finite distributed lag models
In finite distributed lag models, the explanatory variables are
allowed to influence the dependent variable with a time lag

Example for a finite distributed lag model

The fertility rate may depend on the tax value of a child, but
for biological and behavioral reasons, the effect may have a
lag

Children born per Tax Tax Tax

1,000 women in exemption exemption in exemption in
year t in year t year t-1 year t-2

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 Analyzing Time Series:
Basic Regression Analysis
Interpretation of the effects in finite distributed lag
models

Effect of a past shock on the current value of the dep.

variable

Effect of a transitory shock: Effect of permanent shock:

If there is a one time shock in If there is a permanent shock in a past
a past period, the dep. period, i.e. the explanatory variable
variable will change permanently increases by one unit, the
temporarily by the amount effect on the dep. variable will be the
indicated by the coefficient of cumulated effect of all relevant lags. This is a
the corresponding lag. long-run effect on the dependent variable.
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 Analyzing Time Series:
Basic Regression Analysis
Graphical illustration of lagged effects

For example, the effect is

biggest after a lag of one
period. After that, the effect
vanishes (if the initial shock
was transitory).

The long run effect of a

permanent shock is the
cumulated effect of all relevant
lagged effects. It does not
vanish (if the initial shock is a
per-manent one).

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 Analyzing Time Series:
Basic Regression Analysis
Finite sample properties of OLS under classical
assumptions

Assumption TS.1 (Linear in parameters)

The time series involved obey a linear relationship. The stochastic processes
yt, xt1,…, xtk are observed, the error process ut is unobserved. The definition
of the explanatory variables is general, e.g. they may be lags or functions of
other explanatory variables.

„In the sample (and therefore in the underlying time

Assumption TS.2 (No perfect collinearity)
series process), no independent variable is constant
nor a perfect linear combination of the others.“

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 Analyzing Time Series:
Basic Regression Analysis
Notation
This matrix collects all the
information on the complete
time paths of all explanatory
variables

The values of all explanatory

variables in period number t

Assumption TS.3 (Zero conditional mean)

The mean value of the unobserved factors is

unrelated to the values of the explanatory variables
in all periods

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 Analyzing Time Series:
Basic Regression Analysis
Discussion of assumption TS.3

The mean of the error term is unrelated to

Exogeneity: the explanatory variables of the same period

The mean of the error term is unrelated to

Strict the values of the explanatory variables of all
exogeneity: periods
Strict exogeneity is stronger than contemporaneous exogeneity
TS.3 rules out feedback from the dep. variable on future values of the
explanatory variables; this is often questionable esp. if explanatory
variables „adjust“ to past changes in the dependent variable
If the error term is related to past values of the explanatory variables,
one should include these values as contemporaneous regressors

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 Analyzing Time Series:
Basic Regression Analysis
Theorem 10.1 (Unbiasedness of OLS)

Assumption TS.4 (Homoscedasticity)

The volatility of the errors must not be

related to the explanatory variables in any
of the periods
A sufficient condition is that the volatility of the error is independent
of the explanatory variables and that it is constant over time
In the time series context, homoscedasticity may also be easily
violated, e.g. if the volatility of the dep. variable depends on regime
changes

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 Analyzing Time Series:
Basic Regression Analysis
Assumption TS.5 (No serial correlation)

Conditional on the explanatory variables,

the un-observed factors must not be
correlated over time

Discussion of assumption TS.5

Why was such an assumption not made in the cross-sectional case?
The assumption may easily be violated if, conditional on knowing the
values of the indep. variables, omitted factors are correlated over time
The assumption may also serve as substitute for the random sampling
assumption if sampling a cross-section is not done completely
randomly
In this case, given the values of the explanatory variables, errors have
to be uncorrelated across cross-sectional units (e.g. states)

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 Analyzing Time Series:
Basic Regression Analysis
Theorem 10.2 (OLS sampling variances)

Under assumptions TS.1 – TS.5: The same formula as

in the cross-sectional
case

The conditioning on the values of the explanatory variables is not easy to understand.
It effectively means that, in a finite sample, one ignores the sampling variability
coming from the randomness of the regressors. This kind of sampling variability will
normally not be large (because of the sums).

Theorem 10.3 (Unbiased estimation of the error variance)

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 Analyzing Time Series:
Basic Regression Analysis
Theorem 10.4 (Gauss-Markov Theorem)
Under assumptions TS.1 – TS.5, the OLS estimators have the minimal
variance of all linear unbiased estimators of the regression coefficients
This holds conditional as well as unconditional on the regressors

Assumption TS.6 (Normality) This assumption implies TS.3 –

TS.5

independently of

Theorem 10.5 (Normal sampling distributions)

Under assumptions TS.1 – TS.6, the OLS estimators have the usual nor-
mal distribution (conditional on ). The usual F- and t-tests are valid.

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 Analyzing Time Series:
Basic Regression Analysis
Example: Static Phillips curve Contrary to theory, the estimated
Phillips Curve does not suggest a
tradeoff between inflation and
unemployment

The error term contains factors

such as monetary shocks,
income/demand shocks, oil price
Discussion of CLM assumptions shocks, supply shocks, or
exchange rate shocks

TS.1:

TS.2: A linear relationship might be restrictive, but it should be a good

approximation. Perfect collinearity is not a problem as long as
unemployment varies over time.

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 Analyzing Time Series:
Basic Regression Analysis
Discussion of CLM assumptions (cont.)

TS.3: Easily
violated
For example, past unemployment shocks may
lead to future demand shocks which may
dampen inflation
For example, an oil price shock means more
inflation and may lead to future increases in
unemployment
Assumption is violated if
TS.4: monetary policy is more
„nervous“ in times of high
unemployment
TS.5: Assumption is violated if ex-
change rate influences
Questionabl persist over time (they
TS.6: e cannot be explained by
unemployment)

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 Analyzing Time Series:
Basic Regression Analysis
Example: Effects of inflation and deficits on interest rates
Interest rate on 3-months T-bill Government deficit as percentage of
GDP

The error term represents

other factors that determine
interest rates in general,
e.g. business cycle effects
Discussion of CLM assumptions

TS.1:

TS.2: A linear relationship might be restrictive, but it should be a good

approximation. Perfect collinearity will seldomly be a problem in
practice.
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 Analyzing Time Series:
Basic Regression Analysis
Discussion of CLM assumptions (cont.)
Easily
TS.3: violated
For example, past deficit spending may boost
economic activity, which in turn may lead to general
interest rate rises
For example, unobserved demand shocks may
increase interest rates and lead to higher inflation in
future periods
Assumption is violated if higher
TS.4: deficits lead to more uncertainty
about state finances and possibly
more abrupt rate changes
TS.5: Assumption is violated if business
cylce effects persist across years
Questionabl (and they cannot be completely
TS.6: e accounted for by inflation and the
evolution of deficits)

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 Analyzing Time Series:
Basic Regression Analysis
Using dummy explanatory variables in time series

Children born per Tax Dummy for World Dummy for availabity of
1,000 women in exemption War II years (1941- con-traceptive pill (1963-
year t in year t 45) present)

Interpretation
During World War II, the fertility rate was temporarily lower
It has been permanently lower since the introduction of the pill in
1963
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 Analyzing Time Series:
Basic Regression Analysis
Time series with trends

Example for a
time series with a
linear upward
trend

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 Analyzing Time Series:
Basic Regression Analysis
Modelling a linear time trend

Abstracting from random deviations, the

dependent variable increases by a constant
amount per time unit
Alternatively, the expected value of the
dependent variable is a linear function of time

Modelling an exponential time trend

Abstracting from random deviations, the dependent

vari-able increases by a constant percentage per
time unit
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 Analyzing Time Series:
Basic Regression Analysis
Example for a time series with an exponential trend

Abstracting from
random
deviations, the
time series has a
constant growth
rate

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 Analyzing Time Series:
Basic Regression Analysis
Using trending variables in regression analysis
If trending variables are regressed on each other, a spurious
re- lationship may arise if the variables are driven by a
common trend
In this case, it is important to include a trend in the regression

Example: Housing investment and

Per capita housing prices
Housing price
investment index

It looks as if investment
and prices are positively
related

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 Analyzing Time Series:
Basic Regression Analysis
Example: Housing investment and prices (cont.)

There is no significant relationship

between price and investment
anymore
When should a trend be included?
If the dependent variable displays an obvious trending behaviour
If both the dependent and some independent variables have trends
If only some of the independent variables have trends; their effect
on the dep. var. may only be visible after a trend has been
substracted
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 Analyzing Time Series:
Basic Regression Analysis
A Detrending interpretation of regressions with a time trend
It turns out that the OLS coefficients in a regression including a
trend are the same as the coefficients in a regression without a
trend but where all the variables have been detrended before the
regression
This follows from the general interpretation of multiple regressions
Computing R-squared when the dependent variable is trending
Due to the trend, the variance of the dep. var. will be overstated
It is better to first detrend the dep. var. and then run the regression
on all the indep. variables (plus a trend if they are trending as well)
The R-squared of this regression is a more adequate measure of fit

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 Analyzing Time Series:
Basic Regression Analysis
Modelling seasonality in time series
A simple method is to include a set of seasonal dummies:

=1 if obs. from
december
=0 otherwise
Similar remarks apply as in the case of deterministic time trends
The regression coefficients on the explanatory variables can be seen as
the result of first deseasonalizing the dep. and the explanat. variables
An R-squared that is based on first deseasonalizing the dep. var. may
better reflect the explanatory power of the explanatory variables

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