Solutions to the Review Questions at the End of Chapter 6 1.

(a) This is simple to accomplish in theory, but difficult in practice as a result of the algebra. The original equations are (renumbering them (1), (2) and (3) for simplicity)
y1t = 0 + 1 y 2 t + 2 y 3t + 3 X 1t + 4 X 2 t + u1t y 2 t = 0 + 1 y 3t + 2 X 1t + 3 X 3t + u2 t y 3t = 0 + 1 y1t + 2 X 2 t + 3 X 3t + u3t
(1) ( 2) ( 3)

The easiest place to start (I think) is to take equation (1), and substitute in for y3t, to get

y1t = 0 + 1 y 2 t + 2 ( 0 + 1 y1t + 2 X 2 t + 3 X 3t + u3t ) + 3 X 1t + 4 X 2 t + u1t

orking out the products that arise !hen remo"ing the brackets, y1t = 0 + 1 y 2 t + 2 0 + 2 1 y1t + 2 2 X 2 t + 2 3 X 3t + 2 u3t + 3 X 1t + 4 X 2 t + u1t #athering terms in y1t on the $%&'
y1t 2 1 y1t = 0 + 1 y 2 t + 2 0 + 2 2 X 2 t + 2 3 X 3t + 2 u3t + 3 X 1t + 4 X 2 t + u1t

y1t (1 2 1 ) = 0 + 1 y 2 t + 2 0 + 2 2 X 2 t + 2 3 X 3t + 2 u3t + 3 X 1t + 4 X 2 t + u1t

(() )o! substitute into (2) for y3t from (3).

y 2 t = 0 + 1 ( 0 + 1 y1t + 2 X 2 t + 3 X 3t + u3t ) + 2 X 1t + 3 X 3t + u2 t
*emo"ing the brackets y 2 t = 0 + 1 0 + 1 1 y1t + 1 2 X 2 t + 1 3 X 3t + 1u3t + 2 X 1t + 3 X 3t + u2 t (+) &ubstituting into (() for y2t from (+),
y1t (1 2 1 ) = 0 + 1 ( 0 + 1 0 + 1 1 y1t + 2 X 2 t + 1 3 X 3t + 1u3t + 2 X 1t +

3 X 3t + u2 t ) + 2 0 + 2 2 X 2 t + 2 3 X 3t + 2 u3t + 3 X 1t + 4 X 2 t + u1t

Taking the y1t terms to the $%&'

y1t (1 2 1 1 1 1 ) = 0 + 1 0 + 1 1 0 + 1 2 X 2 t + 1 1 3 X 3t + 1 1u3t + 1 2 X 1t +

1 3 X 3t + 1u2 t + 2 0 + 2 2 X 2 t + 2 3 X 3t + 2 u3t + 3 X 1t + 4 X 2 t + u1t

#athering like,terms in the other "ariables together' 1/8 Introductory Econometrics for Finance C ris !roo"s 2008

y1t (1 2 1 1 1 1 ) = 0 + 1 0 + 1 1 0 + 2 0 + X 1t (1 2 + 3 ) + X 2 t (1 1 2 + 2 2 + 4 ) + X 3t (1 1 3 + 1 3 + 2 3 ) + u 3t (1 1 + 2 ) + 1 u2 t + u1t

(-) .ultiplying all through equation (3) by (1 2 1 1 1 1 ) '

y 3t (1 2 1 11 1 ) = 0 (1 2 1 11 1 ) + 1 y1t (1 2 1 11 1 ) +

2 X 2 t (1 2 1 11 1 ) + 3 X 3t (1 2 1 11 1 ) + u3t (1 2 1 11 1 )
*eplacing

y1t (1 2 1 11 1 ) in (/) !ith the *%& of (-),

(/)

0 + 1 0 + 1 1 0 + 2 0 + X1t ( 1 2 + 3) y3t (1 2 1 11 1) = 0(1 2 1 11 1) + 1 + X2t ( 1 1 2 + 2 2 + 4 ) + X3t ( 1 1 3 + 1 3 + 2 3) + u3t ( 1 1 + 2 ) + 1u2t + u1t + 2 X2t (1 2 1 11 1) + 3 X3t (1 2 1 11 1) + u3t (1 2 1 11 1)
(0) 12panding the brackets in equation (0) and cancelling the rele"ant terms

y 3t (1 2 1 11 1 ) = 0 + 1 0 + 11 0 + X 1t (1 2 1 + 1 3 ) + X 2 t ( 2 + 1 4 ) + X 3t ( 11 3 + 3 ) + u3t + 11u2 t + 1u1t

(3) .ultiplying all through equation (2) by (1 2 1 1 1 1 ) '

y 2 t (1 1 11 12 ) = 0 (1 1 1 1 12 ) + 1 y 3t (1 1 11 12 ) +

2 X 1t (1 1 11 12 ) + 3 X 3t (1 1 11 12 ) + u2 t (1 1 1 1 12 )
(14) *eplacing

y3t (1 2 1 11 1 ) in (14) !ith the *%& of (3),

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Introductory Econometrics for Finance C ris !roo"s 2008

 0 + 1 0 + 1 1 0 + X1t ( 1 2 1 + 1 3) + y2t (1 1 1 1 12 ) = 0(1 1 1 1 12 ) + 1 X2t ( 2 + 1 4 ) + X 3t ( 3 + 1 1 3) + u3t + 1 1u2t + 1u1t + 2 X1t (1 1 1 1 12 ) + 3 X3t (1 1 1 1 12 ) + u2t (1 1 1 1 12 )
(11) 12panding the brackets in (11) and cancelling the rele"ant terms

y2 t (1 1 1 1 12 ) = 0 0 2 1 + 1 0 1 1 0 + X 1t X 3t ( 1 3 + 3 3 2 1 ) + 1u3t +u2 t (1 2 1 ) + 1 1u1t

( 1 13 + 2 2 2 1 ) + X 2 t ( 1 2 + 1 1 4)

(12) 5lthough it might not look like it (6), equations (-), (12), and (3) respecti"ely !ill gi"e the reduced form equations corresponding to (1), (2), and (3), by doing the necessary di"ision to make y1t, y2t, or y3t the sub7ect of the formula. 8rom (-),

0 + 1 0 + 1 1 0 + 2 0 ( 1 2 + 3 ) ( + 2 2 + 4 ) + X 1t + 1 1 2 X 2t + (1 2 1 1 1 1 ) (1 2 1 1 1 1 ) (1 2 1 1 1 1 ) ( 1 1 3 + 1 3 + 2 3 ) u ( + 2 ) + 1 u2 t + u1t X 3t + 3t 1 1 (1 2 1 1 1 1 ) (1 2 1 1 1 1 ) (13) 8rom (12),

y1t =

y2 t =

0 02 1 + ( + 22 1 ) 1 0 1 10 + 1 1 3 2 X 1t (1 1 1 (1 1 1 1 12 ) 1 12 )

( 1 2 + 1 14 ) X 2t + (1 1 1 1 12 )

( u + u2 t (1 2 1 ) + 1 3 + 3 32 1 ) 1 1u1t X 3t + 1 3t (1 1 1 (1 1 1 1 12 ) 1 12 )
(1() 8rom (3),

y 3t =

0 + 10 + 1 1 0 ( 1 2 1 + 1 3 ) ( 2 + 1 4 ) + X 1t + X + (1 2 1 11 1 ) (1 2 1 11 1 ) (1 2 1 11 1 ) 2 t

( 1 1 3 + 3 ) u + u + u X 3t + 3t 1 1 2 t 1 1t (1 2 1 11 1 ) (1 2 1 11 1 )
(1+) 3/8 Introductory Econometrics for Finance C ris !roo"s 2008

)otice that all of the reduced form equations (13),(1+) in this case depend on all of the e2ogenous "ariables, !hich is not al!ays the case, and that the equations contain only e2ogenous "ariables on the *%&, !hich must be the case for these to be reduced forms. (b) The term 9identification: refers to !hether or not it is in fact possible to obtain the structural form coefficients (the , , and ;s in equations (1),(3)) from the reduced form coefficients (the ;s) by substitution. 5n equation can be o"er,identified, 7ust,identified, or under,identified, and the equations in a system can ha"e differing orders of identification. If an equation is under, identified (or not identified), then !e cannot obtain the structural form coefficients from the reduced forms using any technique. If it is 7ust identified, !e can obtain unique structural form estimates by back, substitution, !hile if it is o"er,identified, !e cannot obtain unique structural form estimates by substituting from the reduced forms. There are t!o rules for determining the degree of identification of an equation' the rank condition, and the order condition. The rank condition is a necessary and sufficient condition for identification, so if the rule is satisfied, it guarantees that the equation is indeed identified. The rule centres around a restriction on the rank of a sub,matri2 containing the reduced form coefficients, and is rather comple2 and not particularly illuminating, and !as therefore not co"ered in this course. The order condition, can be e2pressed in a number of !ays, one of !hich is the follo!ing. $et G denote the number of structural equations (equal to the number of endogenous "ariables). 5n equation is 7ust identified if G,1 "ariables are absent. If more than G,1 are absent, then the equation is o"er, identified, !hile if fe!er are absent, then it is not identified. 5pplying this rule to equations (1),(3), G<3, so for an equation to be identified, !e require 2 to be absent. The "ariables in the system are y1, y2, y3, X1, X2, X3. Is this the case= 1quation (1)' X3t only is missing, so the equation is not identified. 1quation (2)' y1t and X2t are missing, so the equation is 7ust identified. 1quation (3)' y2t and X1t are missing, so the equation is 7ust identified. %o!e"er, the order condition is only a necessary (and not a sufficient) condition for identification, so there !ill e2ist cases !here a gi"en equation satisfies the order condition, but !e still cannot obtain the structural form coefficients. 8ortunately, for small systems this is rarely the case. 5lso, in practice, most systems are designed to contain equations that are o"er, identified. (c). It !as stated in >hapter ( that omitting a rele"ant "ariable from a regression equation !ould lead to an 9omitted "ariable bias: (in fact an inconsistency as !ell), !hile including an irrele"ant "ariable !ould lead to unbiased but inefficient coefficient estimates. There is a direct analogy !ith the simultaneous "ariable case. Treating a "ariable as e2ogenous !hen it really

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should be endogenous because there is some feedback, !ill result in biased and inconsistent parameter estimates. ?n the other hand, treating a "ariable as endogenous !hen it really should be e2ogenous (that is, ha"ing an equation for the "ariable and then substituting the fitted "alue from the reduced form if 2&$& is used, rather than 7ust using the actual "alue of the "ariable) !ould result in unbiased but inefficient coefficient estimates. If !e take the "ie! that consistency and unbiasedness are more important that efficiency (!hich is the "ie! that I think most econometricians !ould take), this implies that treating an endogenous "ariable as e2ogenous represents the more se"ere mis,specification. &o if in doubt, include an equation for it6 (5lthough, of course, !e can test for e2ogeneity using a %ausman,type test). (d). 5 tempting response to the question might be to describe indirect least squares (I$&), that is estimating the reduced form equations by ?$& and then substituting back to get the structural forms@ ho!e"er, this response !ould be *?)#, since the question tells us that the system is o"er,identified. 5 correct ans!er !ould be to describe either t!o stage least squares (2&$&) or instrumental "ariables (IA). 1ither !ould be acceptable, although IA requires the user to determine an appropriate set of instruments and hence 2&$& is simpler in practice. 2&$& in"ol"es estimating the reduced form equations, and obtaining the fitted "alues in the first stage. In the second stage, the structural form equations are estimated, but replacing the endogenous "ariables on the *%& !ith their stage one fitted "alues. 5pplication of this technique !ill yield unique and unbiased structural form coefficients. 2. (a) 5 glance at equations (-.3/) and (-.30) re"eals that the dependent "ariable in (-.3/) appears as an e2planatory "ariable in (-.30) and that the dependent "ariable in (-.30) appears as an e2planatory "ariable in (-.3/). The result is that it !ould be possible to sho! that the e2planatory "ariable y2t in (-.3/) !ill be correlated !ith the error term in that equation, u1t, and that the e2planatory "ariable y1t in (-.30) !ill be correlated !ith the error term in that equation, u2t. Thus, there is causality from y1t to y2t and from y2t to y1t, so that this is a simultaneous equations system. If ?$& !ere applied separately to each of equations (-.3/) and (-.30), the result !ould be biased and inconsistent parameter estimates. That is, e"en !ith an infinitely large number of obser"ations, ?$& could not be relied upon to deli"er the appropriate parameter estimates. (b) If the "ariable y1t had not appeared on the *%& of equation (-.30), this !ould no longer be a simultaneous system, but !ould instead be an e2ample of a triangular system (see question 3). Thus it !ould be "alid to apply ?$& separately to each of the equations (-.3/) and (-.30). (c) The order condition for determining !hether an equation from a simultaneous system is identified !as described in question 1, part (b). There are 2 equations in the system of (-.3/) and (-.30), so that only 1 "ariable

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Introductory Econometrics for Finance C ris !roo"s 2008

!ould ha"e to be missing from an equation to make it 7ust identified. If no "ariables are absent, the equation !ould not be identified, !hile if more than one !ere missing, the equation !ould be o"er,identified. >onsidering equation (-.3/), no "ariables are missing so that this equation is not identified, !hile equation (-.30) e2cludes only "ariable X2t, so that it is 7ust identified. (d) &ince equation (-.3/) is not identified, no method could be used to obtain estimates of the parameters of this equation, !hile either I$& or 2&$& could be used to obtain estimates of the parameters of (-.30), since it is 7ust identified. I$& operates by obtaining and estimating the reduced form equations and then obtaining the structural parameters of (-.30) by algebraic back, substitution. 2&$& in"ol"es again obtaining and estimating the reduced form equations, and then estimating the structural equations but replacing the endogenous "ariables on the *%& of (-.3/) and (-.30) !ith their reduced form fitted "alues. >omparing bet!een I$& and 2&$&, the former method only requires one set of estimations rather than t!o, but this is about its only ad"antage, and conducting a second stage ?$& estimation is usually a computationally tri"ial e2ercise. The primary disad"antage of I$& is that it is only applicable to 7ust identified equations, !hereas many sets of equations that !e may !ish to estimate are o"er,identified. &econd, obtaining the structural form coefficients "ia algebraic substitution can be a "ery tedious e2ercise in the conte2t of large systems (as the solution to question 1, part (a) sho!s6). (e) The %ausman procedure !orks by first obtaining and estimating the reduced form equations, and then estimating the structural form equations separately using ?$&, but also adding the fitted "alues from the reduced form estimations as additional e2planatory "ariables in the equations !here those "ariables appear as endogenous *%& "ariables. Thus, if the reduced form fitted "alues corresponding to equations (-.3/) and (-.30) are gi"en by y1t and y2t respecti"ely, the %ausmann test equations !ould be
y1t = 0 + 1 y 2t + 2 X 1t + 3 X 2t + 4 y 2t $+u1t y 2t = 0 + 1 y1t + 2 X 1t + 3 y1t $+ u1t

&eparate tests of the significance of the y1t and y2t terms !ould then be performed. If it !ere concluded that they !ere both significant, this !ould imply that additional e2planatory po!er can be obtained by treating the "ariables as endogenous. 3. 5n e2ample of a triangular system !as gi"en in &ection -./. >onsider a scenario !here there are only t!o 9endogenous: "ariables. The key distinction bet!een this and a fully simultaneous system is that in the case of a triangular system, causality runs only in one direction, !hereas for a simultaneous equation, it !ould run in both directions. Thus, to gi"e an e2ample, for the system to be triangular, y1 could appear in the equation for y2 and not "ice

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"ersa. 8or the simultaneous system, y1 !ould appear in the equation for y2, and y2 !ould appear in the equation for y1. (. (a) p<2 and k<3 implies that there are t!o "ariables in the system, and that both equations ha"e three lags of the t!o "ariables. The A5* can be !ritten in long,hand form as'
y1t = 10 + 111 y1t 1 + 211 y 2t 1 + 112 y1t 2 + 212 y 2t 2 + 113 y1t 3 + 213 y 2t 3 + u1t y 2t = 20 + 121 y1t 1 + 221 y 2t 1 + 122 y1t 2 + 222 y 2t 2 + 123 y1t 3 + 223 y 2t 3 + u 2t

10 y1t u1t !here 0 = & y t = & ut = , and the coefficients on the lags of yt 20 y2t u2 t
are defined as follo!s' ijk refers to the kth lag of the ith "ariable in the jth equation. This seems like a natural notation to use, although of course any sensible alternati"e !ould also be correct. (b) This is basically a 9!hat are the ad"antages of A5*s compared !ith structural models=: type question, to !hich a simple and effecti"e response !ould be to list and e2plain the points made in the book. The most important point is that structural models require the researcher to specify some "ariables as being e2ogenous (if all "ariables !ere endogenous, then none of the equations !ould be identified, and therefore estimation of the structural equations !ould be impossible). This can be "ie!ed as a restriction (a restriction that the e2ogenous "ariables do not ha"e any simultaneous equations feedback), often called an 9identifying restriction:. Betermining !hat are the identifying restrictions is supposed to be based on economic or financial theory, but &ims, !ho first proposed the A5* methodology, argued that such restrictions !ere 9incredible:. %e thought that they !ere too loosely based on theory, and !ere often specified by researchers on the basis of gi"ing the restrictions that the models required to make the equations identified. Cnder a A5*, all the "ariables ha"e equations, and so in a sense, e"ery "ariable is endogenous, !hich takes the ability to cheat (either deliberately or inad"ertently) or to mis,specify the model in this !ay, out of the hands of the researcher. 5nother possible reason !hy A5*s are popular in the academic literature is that standard form A5*s can be estimated using ?$& since all of the lags on the *%& are counted as pre,determined "ariables. 8urther, a glance at the academic literature !hich has sought to compare the forecasting accuracies of structural models !ith A5*s, re"eals that A5*s seem to be rather better at forecasting (perhaps because the identifying restrictions are not "alid). Thus, from a purely pragmatic point of "ie!, researchers may prefer A5*s if the purpose of the modelling e2ercise is to produce precise point forecasts.

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Introductory Econometrics for Finance C ris !roo"s 2008

(c) A5*s ha"e, of course, also been sub7ect to criticisms. The most important of these criticisms is that A5*s are atheoretical. In other !ords, they use "ery little information form economic or financial theory to guide the model specification process. The result is that the models often ha"e little or no theoretical interpretation, so that they are of limited use for testing and e"aluating theories. &econd, A5*s can often contain a lot of parameters. The resulting loss in degrees of freedom if the A5* is unrestricted and contains a lot of lags, could lead to a loss of efficiency and the inclusion of lots of irrele"ant or marginally rele"ant terms. Third, it is not clear ho! the A5* lag lengths should be chosen. Bifferent methods are a"ailable (see part (d) of this question), but they could lead to !idely differing ans!ers. 8inally, the "ery tools that ha"e been proposed to help to obtain useful information from A5*s, i.e. impulse responses and "ariance decompositions, are themsel"es difficult to interpret6 D &ee *unkle (130/). (d) The t!o methods that !e ha"e e2amined are model restrictions and information criteria. Betails on ho! these !ork are contained in &ections -.12.( and -.12.+. Eut briefly, the model restrictions approach in"ol"es starting !ith the larger of the t!o models and testing !hether it can be restricted do!n to the smaller one using the likelihood ratio test based on the determinants of the "ariance,co"ariance matrices of residuals in each case. The alternati"e approach !ould be to e2amine the "alue of "arious information criteria and to select the model that minimises the criteria. &ince there are only t!o models to compare, either technique could be used. The restriction approach assumes normality for the A5* error terms, !hile use of the information criteria does not. ?n the other hand, the information criteria can lead to quite different ans!ers depending on !hich criterion is used and the se"erity of its penalty term. 5 completely different approach !ould be to put the A5*s in the situation that they !ere intended for (e.g. forecasting, making trading profits, determining a hedge ratio etc.), and see !hich one does best in practice6

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