Springer Texts in Business and Economics
Klaus Neusser
Time Series Econometrics
Springer Texts in Business and Economics
More information about this series at http://www.springer.com/series/10099
Klaus Neusser
Time Series Econometrics
123
Klaus Neusser 

Bern, Switzerland 

ISSN 21924333 
ISSN 21924341 
(electronic) 
Springer Texts in Business and Economics
ISBN 9783319328614 DOI 10.1007/9783319328621
ISBN 9783319328621
(eBook)
Library of Congress Control Number: 2016938514
© Springer International Publishing Switzerland 2016 This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of the material is concerned, speciﬁcally the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microﬁlms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a speciﬁc statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made.
Printed on acidfree paper
This Springer imprint is published by Springer Nature The registered company is Springer International Publishing AG Switzerland
Preface
Over the past decades, time series analysis has experienced a proliferous increase of applications in economics, especially in macroeconomics and ﬁnance. Today these tools have become indispensable to any empirically working economist. Whereas in the beginning the transfer of knowledge essentially ﬂowed from the natural sciences, especially statistics and engineering, to economics, over the years theoretical and applied techniques speciﬁcally designed for the nature of economic time series and models have been developed. Thereby, the estimation and identiﬁcation of structural vector autoregressive models, the analysis of integrated and cointegrated time series, and models of volatility have been extremely fruitful and farreaching areas of research. With the award of the Nobel Prizes to Clive W. J. Granger and Robert F. Engle III in 2003 and to Thomas J. Sargent and Christopher A. Sims in 2011, the ﬁeld has reached a certain degree of maturity. Thus, the idea suggests itself to assemble the vast amount of material scattered over many papers into a comprehensive textbook. The book is selfcontained and addresses economics students who have already some prerequisite knowledge in econometrics. It is thus suited for advanced bachelor, master’s, or beginning PhD students but also for applied researchers. The book tries to bring them in a position to be able to follow the rapidly growing research literature and to implement these techniques on their own. Although the book is trying to be rigorous in terms of concepts, deﬁnitions, and statements of theorems, not all proofs are carried out. This is especially true for the more technically and lengthy proofs for which the reader is referred to the pertinent literature. The book covers approximately a twosemester course in time series analysis and is divided in two parts. The ﬁrst part treats univariate time series, in particular autoregressive movingaverage processes. Most of the topics are standard and can form the basis for a onesemester introductory time series course. This part also contains a chapter on integrated processes and on models of volatility. The latter topics could be included in a more advanced course. The second part is devoted to multivariate time series analysis and in particular to vector autoregressive processes. It can be taught independently of the ﬁrst part. The identiﬁcation, modeling, and estimation of these processes form the core of the second part. A special chapter treats the estimation, testing, and interpretation of cointegrated systems. The book also contains a chapter with an introduction to state space models and the Kalman
v
vi
Preface
ﬁlter. Whereas the books is almost exclusively concerned with linear systems, the last chapter gives a perspective on some more recent developments in the context of nonlinear models. I have included exercises and worked out examples to deepen the teaching and learning content. Finally, I have produced ﬁve appendices which summarize important topics such as complex numbers, linear difference equations, and stochastic convergence. As time series analysis has become a tremendously growing ﬁeld with an active research in many directions, it goes without saying that not all topics received the attention they deserved and that there are areas not covered at all. This is especially true for the recent advances made in nonlinear time series analysis and in the application of Bayesian techniques. These two topics alone would justify an extra book. The data manipulations and computations have been performed using the software packages EVIEWS and MATLAB. ^{1} Of course, there are other excellent packages available. The data for the examples and additional information can be downloaded from my home page www.neusser.ch. To maximize the learning success, it is advised to replicate the examples and to perform similar exercises with alternative data. Interesting macroeconomic time series can, for example, be downloaded from the following home pages:
Germany: www.bundesbank.de Switzerland: www.snb.ch United Kingdom: www.statistics.gov.uk United States: research.stlouisfed.org/fred2 The book grew out of lectures which I had the occasion to give over the years in Bern and other universities. Thus, it is a concern to thank the many students, in particular Philip Letsch, who had to work through the manuscript and who called my attention to obscurities and typos. I also want to thank my colleagues and teaching assistants Andreas Bachmann, Gregor Bäurle, Fabrice Collard, Sarah Fischer, Stephan Leist, Senada Nukic, Kurt Schmidheiny, Reto Tanner, and Martin Wagner for reading the manuscript or part of it and for making many valuable criticisms and comments. Special thanks go to my former colleague and coauthor Robert Kunst who meticulously read and commented on the manuscript. It goes without saying that all errors and shortcomings go to my expense.
Bern, Switzerland/Eggenburg, Austria February 2016
Klaus Neusser
^{1} EVIEWS is a product of IHS Global Inc. MATLAB is a matrixoriented software developed by MathWorks which is ideally suited for econometric and time series applications.
Contents
Part I
Univariate Time Series Analysis
1 Introduction 
3 

1.1 Some Examples 
4 

1.2 Formal Deﬁnitions 
7 

1.3 Stationarity 
11 

1.4 Construction of Stochastic Processes 
15 

1.4.1 White Noise 
15 

1.4.2 Construction of Stochastic Processes: Some Examples 
16 

1.4.3 MovingAverage Process of Order One 
17 

1.4.4 Random Walk 
19 

1.4.5 Changing Mean 
20 

1.5 
Properties of the Autocovariance Function 
20 

1.5.1 
Autocovariance Function of MA(1) Processes 
21 

1.6 
Exercises 
22 

2 ARMA Models 
25 

2.1 The Lag Operator 
26 

2.2 Some Important Special Cases 
27 

2.2.1 MovingAverage Process of Order q 
27 

2.2.2 First Order Autoregressive Process 
29 

2.3 Causality and Invertibility 
32 

2.4 Computation of Autocovariance Function 
38 

2.4.1 First Procedure 
39 

2.4.2 Second Procedure 
41 

2.4.3 Third Procedure 
43 

2.5 Exercises 
44 

3 Forecasting Stationary Processes 
45 

3.1 Linear LeastSquares Forecasts 
45 

3.1.1 Forecasting with an AR(p) Process 
48 

3.1.2 Forecasting with MA(q) Processes 
50 

3.1.3 Forecasting from the Inﬁnite Past 
53 

3.2 The Wold Decomposition Theorem 
54 

3.3 Exponential Smoothing 
58 
vii
viii
Contents
3.4 Exercises 
60 

3.5 Partial Autocorrelation 
61 

3.5.1 
Deﬁnition 
62 
3.5.2 
Interpretation of ACF and PACF 
64 
3.6 Exercises 
65 

4 Estimation of Mean and ACF 
67 

4.1 Estimation of the Mean 
67 

4.2 Estimation of ACF 
73 

4.3 Estimation of PACF 
78 

4.4 Estimation of the LongRun Variance 
79 

4.4.1 
An Example 
83 
4.5 Exercises 
85 

5 Estimation of ARMA Models 
87 

5.1 The YuleWalker Estimator 
87 

5.2 OLS Estimation of an AR(p) Model 
91 

5.3 Estimation of an ARMA(p,q) Model 
94 

5.4 Estimation of the Orders p and q 
99 

5.5 Modeling a Stochastic Process 
102 

5.6 Modeling Real GDP of Switzerland 
103 

6 Spectral Analysis and Linear Filters 
109 

6.1 Spectral Density 
110 

6.2 Spectral Decomposition of a Time Series 
113 

6.3 The Periodogram and the Estimation of Spectral Densities 
117 

6.3.1 NonParametric Estimation 
117 

6.3.2 Parametric Estimation 
121 

6.4 Linear TimeInvariant Filters 
122 

6.5 Some Important Filters 
127 

6.5.1 Construction of Low and HighPass Filters 
127 

6.5.2 The HodrickPrescott Filter 
128 

6.5.3 Seasonal Filters 
130 

6.5.4 Using Filtered Data 
131 

6.6 Exercises 
132 

7 Integrated Processes 
133 

7.1 Deﬁnition, Properties and Interpretation 
133 

7.1.1 LongRun Forecast 
135 

7.1.2 Variance of Forecast Error 
136 

7.1.3 Impulse Response Function 
137 

7.1.4 The BeveridgeNelson Decomposition 
138 

7.2 Properties of the OLS Estimator in the Case of Integrated Variables 
141 

7.3 UnitRoot Tests 
145 

7.3.1 
DickeyFuller Test 
147 
7.3.2
PhillipsPerron Test
149
Contents
ix
7.3.3 UnitRoot Test: Testing Strategy 
150 

7.3.4 Examples of UnitRoot Tests 
152 

7.4 Generalizations of UnitRoot Tests 
153 

7.4.1 Structural Breaks in the Trend Function 
153 

7.4.2 Testing for Stationarity 
157 

7.5 Regression with Integrated Variables 
158 

7.5.1 The Spurious Regression Problem 
158 

7.5.2 Bivariate Cointegration 
159 

7.5.3 Rules to Deal with Integrated Times Series 
162 

8 Models of Volatility 
167 

8.1 Speciﬁcation and Interpretation 
168 

8.1.1 Forecasting Properties of AR(1)Models 
168 

8.1.2 The ARCH(1) Model 
169 

8.1.3 General Models of Volatility 
173 

8.1.4 The GARCH(1,1) Model 
177 

8.2 Tests for Heteroskedasticity 
183 

8.2.1 Autocorrelation of Quadratic Residuals 
183 

8.2.2 Engle’s LagrangeMultiplier Test 
184 

8.3 Estimation of GARCH(p,q) Models 
184 

8.3.1 MaximumLikelihood Estimation 
184 

8.3.2 Method of Moment Estimation 
187 

8.4 Example: Swiss Market Index (SMI) 
188 

Part II 
Multivariate Time Series Analysis 

9 Introduction 
197 

10 Deﬁnitions and Stationarity 
201 

11 Estimation of Covariance Function 
207 

11.1 Estimators and Asymptotic Distributions 
207 

11.2 Testing CrossCorrelations of Time Series 
209 

11.3 Some Examples for Independence Tests 
211 

12 VARMA Processes 
215 

12.1 The VAR(1) Process 
216 

12.2 Representation in Companion Form 
218 

12.3 Causal Representation 
218 

12.4 Computation of Covariance Function 
221 

13 Estimation of VAR Models 
225 

13.1 Introduction 
225 

13.2 The LeastSquares Estimator 
226 

13.3 Proofs of Asymptotic Normality 
231 
13.4
The YuleWalker Estimator
238
x
Contents
14 Forecasting with VAR Models 
241 

14.1 Forecasting with Known Parameters 
241 

14.1.1 
Wold Decomposition Theorem 
245 

14.2 Forecasting with Estimated Parameters 
245 

14.3 Modeling of VAR Models 
247 

14.4 Example: VAR Model 
248 

15 Interpretation of VAR Models 
255 

15.1 WienerGranger Causality 
255 

15.1.1 VAR Approach 
256 

15.1.2 WienerGranger Causality and Causal Representation 
258 

15.1.3 CrossCorrelation Approach 
259 

15.2 Structural and Reduced Form 
260 

15.2.1 A Prototypical Example 
260 

15.2.2 Identiﬁcation: The General Case 
263 

15.2.3 Identiﬁcation: The Case n D 2 
266 

15.3 Identiﬁcation via ShortRun Restrictions 
268 

15.4 Interpretation of VAR Models 
270 

15.4.1 Impulse Response Functions 
270 

15.4.2 Variance Decomposition 
270 

15.4.3 Conﬁdence Intervals 
272 

15.4.4 Example 1: Advertisement and Sales 
274 

15.4.5 Example 2: ISLM Model with Phillips Curve 
277 

15.5 Identiﬁcation via LongRun Restrictions 
282 

15.5.1 A Prototypical Example 
282 

15.5.2 The General Approach 
285 

15.6 Sign Restrictions 
289 

16 Cointegration 
295 

16.1 A Theoretical Example 
296 

16.2 Deﬁnition and Representation 
302 

16.2.1 Deﬁnition 
302 

16.2.2 VAR and VEC Models 
305 

16.2.3 BeveridgeNelson Decomposition 
308 

16.2.4 Common Trend Representation 
310 

16.3 Johansen’s Cointegration Test 
311 

16.3.1 Speciﬁcation of the Deterministic Components 
317 

16.3.2 Testing Cointegration Hypotheses 
318 

16.4 Estimation and Testing of Cointegrating Relationships 
319 

16.5 An Example 
321 

17 Kalman Filter 
325 

17.1 
The State Space Model 
326 

17.1.1 
Examples 
328 
17.2
Filtering and Smoothing
336
Contents
xi
17.2.1 The Kalman Filter 
339 
17.2.2 The Kalman Smoother 
340 
17.3 Estimation of State Space Models 
343 
17.3.1 The Likelihood Function 
344 
17.3.2 Identiﬁcation 
346 
17.4 Examples 
346 
17.4.1 Estimation of Quarterly GDP 
346 
17.4.2 Structural Time Series Analysis 
349 
17.5 Exercises 
350 
18 Generalizations of Linear Models 
353 
18.1 Structural Breaks 
353 
18.1.1 Methodology 
354 
18.1.2 An Example 
356 
18.2 TimeVarying Parameters 
357 
18.3 Regime Switching Models 
364 
A Complex Numbers 
369 
B Linear Difference Equations 
373 
C Stochastic Convergence 
377 
D BNDecomposition 
383 
E The Delta Method 
387 
Bibliography 
391 
Index 
403 
List of Figures
Fig. 1.1 
Real gross domestic product (GDP) 
5 

Fig. 1.2 
Growth rate of real gross domestic product (GDP) 
5 

Fig. 
1.3 
Swiss real gross domestic product 
6 
Fig. 1.4 
Short and longterm Swiss interest rates 
7 

Fig. 1.5 
Swiss Market Index (SMI). (a) Index. (b) Daily return 
8 

Fig. 1.6 
Unemployment rate in Switzerland 
9 

Fig. 
1.7 
Realization of a random walk 
12 
Fig. 1.8 
Realization of a branching process 
12 

Fig. 1.9 
Processes constructed from a given white noise 

process. (a) White noise. (b) Movingaverage with D 0:9. (c) Autoregressive with D 0:9. (d) Random walk 
17 

Fig. 1.10 
Relation between the autocorrelation coefﬁcient of 

order one, .1/, and the parameter of a MA(1) process 
23 

Fig. 2.1 
Realization and estimated ACF of MA(1) process 
28 

Fig. 2.2 
Realization and estimated ACF of an AR(1) process 
31 

Fig. 2.3 
Autocorrelation function of an ARMA(2,1) process 
42 

Fig. 3.1 
Autocorrelation and partial autocorrelation functions. (a) Process 1. (b) Process 2. (c) Process 3. (d) Process 4 
66 

Fig. 4.1 
Estimated autocorrelation function of a WN(0,1) process 
75 

Fig. 4.2 
Estimated autocorrelation function of MA(1) process 
76 

Fig. 4.3 
Estimated autocorrelation function of an AR(1) process 
77 

Fig. 4.4 
Estimated PACF of an AR(1) process 
78 

Fig. 4.5 
Estimated PACF for a MA(1) process 
79 

Fig. 4.6 
Common kernel functions 
81 

Fig. 4.7 
Estimated autocorrelation function for the growth rate 

of GDP 
84 

Fig. 5.1 
Parameter space of causal and invertible ARMA(1,1) process 
100 

Fig. 5.2 
Real GDP growth rates of Switzerland 
104 

Fig. 5.3 
ACF and PACF of GDP growth rate 
105 

Fig. 5.4 
Inverted roots of the ARMA(1,3) model 
106 

Fig. 5.5 
ACF of the residuals from AR(2) and ARMA(1,3) models 
107 

Fig. 5.6 
Impulse responses of the AR(2) and the ARMA(1,3) model 
107 
xiii
xiv
List of Figures
Fig. 5.7 
Forecasts of real GDP growth rates 

Fig. 6.1 
Examples of spectral densities with Z _{t} WN.0; 1/. 

(a) 
MA(1) process. (b) AR(1) process 

Fig. 6.2 
Raw periodogram of a white noise time series Distribution of the OLS estimator 

Fig. 6.3 
(X _{t} WN.0; 1/, T D 200) Raw periodogram of an AR(2) process 

Fig. 6.4 
(X _{t} D 0:9X _{t} _{} _{1} 0:7X _{t} _{} _{2} C Z _{t} with Z _{t} WN.0; 1/, T D 200) Nonparametric direct estimates of a spectral density 

Fig. 6.5 
Nonparametric and parametric estimates of spectral density 

Fig. 6.6 
Transfer function of the Kuznets ﬁlters 

Fig. 6.7 
Transfer function of HPﬁlter 

Fig. 6.8 
HPﬁltered US GDP 

Fig. 6.9 
Transfer function of growth rate of investment in the 

Fig. 7.1 
construction sector with and without seasonal adjustment 

Fig. 7.2 
Distribution of tstatistic and standard normal distribution 

Fig. 7.3 
ACF of a random walk with 100 observations 

Fig. 
7.4 
Three types of structural breaks at T _{B} . (a) Level shift. 
(b) Change in slope. (c) Level shift and change in slope
Fig. 7.5
Fig. 7.6
Fig. 8.1
Fig. 8.2
Fig. 8.3
Fig. 8.4
Fig. 8.5
Fig. 8.6
Fig. 11.1
Fig. 11.2
Fig. 11.3
Fig. 14.1
Fig. 14.2
O
Distribution of OLSestimate ˇ and tstatistic t
two independent random walks and two independent
O
ˇ
for
O
AR(1) processes. (a) Distribution of ˇ. (b) Distribution
of t
Cointegration of inﬂation and threemonth LIBOR. (a) Inﬂation and threemonth LIBOR. (b) Residuals from cointegrating regression
Simulation of two ARCH(1) processes Parameter region for which a strictly stationary solution to the GARCH(1,1) process exists assuming _{t} IID N.0; 1/ Daily return of the SMI (Swiss Market Index) NormalQuantile Plot of SMI returns Histogram of SMI returns ACF of the returns and the squared returns of the SMI
Crosscorrelations between two independent AR(1) processes Crosscorrelations between consumption and advertisement Crosscorrelations between GDP and consumer sentiment
Forecast comparison of alternative models. (a) log Y _{t} .
(b) log P _{t} . (c) log M _{t} . (d) R _{t}
Forecast of VAR(8) model and 80 % conﬁdence intervals
O
ˇ O . (c) Distribution of ˇ and tstatistic t
O
ˇ
108
114
120
121
121
123
127
129
130
131
142
144
145
154
160
163
174
180
188
189
190
190
212
213
214
251
253
Fig. 15.1
Identiﬁcation in a twodimensional structural VAR
267
List of Figures
xv
Fig. 15.2 
Impulse response functions for advertisement and sales 
276 

Fig. 15.3 
Impulse response functions of ISLM model 
280 

Fig. 15.4 
Impulse response functions of the BlanchardQuah model 
289 

Fig. 16.1 
Impulse responses of present discounted value model 
302 

Fig. 16.2 
Stochastic simulation of present discounted value model 
303 

Fig. 17.1 
State space model 
326 

Fig. 17.2 
Spectral density of cyclical component 
334 

Fig. 17.3 
Estimates of quarterly GDP growth rates 
349 

Fig. 17.4 
Components of the basic structural model (BSM) for 

real GDP of Switzerland. (a) Logged Swiss GDP (demeaned). (b) Local linear trend (LLT). (c) Business cycle component. (d) Seasonal component 
350 

Fig. 
18.1 
Break date UK 
357 
Fig. A.1 
Representation of a complex number 
370 
List of Tables
Table 1.1 
Construction of stochastic processes 
17 

Table 3.1 
Forecast function for a MA(1) process with D 0:9 

and ^{2} D 1 
52 

Table 3.2 
Properties of the ACF and the PACF 
65 

Table 
4.1 
Common kernel functions 
81 
Table 
5.1 
AIC for alternative ARMA(p,q) models 
105 
Table 5.2 
BIC for alternative ARMA(p,q) models 
106 

Table 7.1 
The four most important cases for the unitroot test 
147 

Table 7.2 
Examples of unit root tests 
153 

Table 7.3 
DickeyFuller regression allowing for structural breaks 
155 

Table 7.4 
Critical values of the KPSS test 
158 

Table 7.5 
Rules of thumb in regressions with integrated processes 
165 

Table 8.1 
AIC criterion for variance equation in GARCH(p,q) model 
191 

Table 8.2 
BIC criterion for variance equation in GARCH(p,q) model 
191 

Table 8.3 
One percent VaR for the next day of the return on SMI 
193 

Table 
8.4 
One percent VaR for the next 10 days of the return on SMI 
193 
Table 14.1 
Information criteria for the VAR models of different orders 
249 

Table 14.2 
Forecast evaluation of alternative VAR models 
252 

Table 15.1 
Forecast error variance decomposition (FEVD) in terms of demand, supply, price, wage, and money shocks (percentages) 
281 

Table 16.1 
Trend speciﬁcations in vector error correction models 
318 

Table 16.2 
Evaluation of the results of Johansen’s cointegration test 
322 
xvii
List of Deﬁnitions
1.3 
Model 
10 
1.4 
Autocovariance Function 
13 
1.5 
Stationarity 
13 
1.6 
Strict Stationarity 
14 
1.7 
Strict Stationarity 
14 
1.8 
Gaussian Process 
15 
1.9 
White Noise 
15 
2.1 
ARMA Models 
25 
2.2 
Causality 
32 
2.3 
Invertibility 
37 
3.1 
Deterministic Process 
54 
3.2 
Partial Autocorrelation Function I 
62 
3.3 
Partial Autocorrelation Function II 
62 
6.1 
Spectral Density 
110 
6.2 
Periodogram 
118 
7.2 
Cointegration, Bivariate 
159 
8.1 
ARCH(1) Model 
169 
10.2 
Stationarity 
202 
10.3 
Strict Stationarity 
203 
12.1 
VARMA process 
215 
15.2 
Sign Restrictions 
291 
16.3 
Cointegration 
305 
C.1 
Almost Sure Convergence 
378 
C.2 
Convergence in Probability 
378 
C.3 
Convergence in rth Mean 
378 
xix
xx
List of Deﬁnitions
C.4 
Convergence in Distribution 
379 
C.5 
Characteristic Function 
380 
C.6 
Asymptotic Normality 
381 
C.7 
mDependence 
381 
List of Theorems
3.1 
Wold Decomposition 
55 
4.1 
Convergence of Arithmetic Average 
68 
4.2 
Asymptotic Distribution of Sample Mean 
69 
4.4 
Asymptotic Distribution of Autocorrelations 
74 
5.1 
Asymptotic Normality of YuleWalker Estimator 
89 
5.2 
Asymptotic Normality of the LeastSquares Estimator 
92 
5.3 
Asymptotic Distribution of ML Estimator 
98 
6.1 
Properties of a Spectral Density 
111 
6.2 
Spectral Representation 
115 
6.3 
Spectral Density of ARMA Processes 
121 
6.4 
Autocovariance Function of Filtered Process 
123 
7.1 
BeveridgeNelson Decomposition 
139 
13.1 
Asymptotic Distribution of OLS Estimator 
229 
16.1 
BeveridgeNelson Decomposition 
304 
18.1 
Solution TVCVAR(1) 
358 
C.1 
CauchyBunyakovskiiSchwarz Inequality 
377 
C.2 
Minkowski’s Inequality 
377 
C.3 
Chebyschev’s Inequality 
377 
C.4 
BorelCantelli Lemma 
378 
C.5 
Kolmogorov’s Strong Law of Large Numbers (SLLN) 
378 
C.6 
RieszFisher 
379 
C.9 
Continuous Mapping Theorem 
380 
C.10 
Slutzky’s Lemma 
380 
C.11 Convergence of Characteristic Functions, Lévy 
381 

C.12 Central Limit Theorem 
381 

C.13 CLT for mDependent Processes 
381 

C.14 
Basis Approximation Theorem 
382 
xxi
Notation and Symbols
r number of linearly independent cointegration vectors
˛ n r loading matrix
ˇ n r matrix of linearly independent cointegration vectors
d
!
m:s:
!
convergence in distribution
convergence in mean square
p 
convergence in probability 
! 

corr.X; Y/ _{X} ; _{X} ; 
correlation coefﬁcient beween random variables X and Y covariance function of process fX _{t} g, covariance function correlation function of process fX _{t} g, correlation function 
ACF 
autocorrelation function 
J 
longrun variance 
˛ _{X} ; ˛ 
partial autocorrelation function of process fX _{t} g 
PACF 
partial autocorrelation function 
n 
dimension of stochastic process, respectively dimension of state 

space is distributed as 
sgn 
sign function 
tr 
trace of a matrix 
det 
determinant of a matrix 
kk 
norm of a matrix 
˝ 
Kronecker product 
ˇ 
Hadamard product 
vec.A/ 
stakes the columns of A into a vector 
vech.A/ 
stakes the lower triangular part of a symmetric matrix A into a 
GL.n/ 
vector general linear group of n n matrices 
O .n/ 
group of orthogonal n n matrices 
L 
lag operator 
xxiii
xxiv
Notation and Symbols
ˆ.L/
‚.L/
‰.L/
p order of autoregressive polynomial
q
ARMA(p,q)
ARIMA(p,d,q)
autoregressive polynomial movingaverage polynomial causal representation, MA.1/ polynomial difference operator, D 1 L
order of movingaverage polynomial autoregressive movingaverage process of order .p; q/ autoregressive integrated movingaverage process of order .p; d; q/
order of integration integrated process of order d vector autoregressive process of order p
d
I(d)
VAR(p)
Z integer numbers
R real numbers
C
R ^{n}
{
cov.X; Y/
E expectation operator
V variance operator
‰.1/
complex numbers set of ndimensional vectors
imaginary unit covariance beween random variables X and Y
persistence linear leastsquares predictor of X _{T}_{C}_{h} given information from
period 1 up to period T
linear leastsquares predictor of X _{T}_{C}_{h} using the inﬁnite remote past up to period T Probability stochastic process
white noise process with mean zero and variance ^{2}
multivariate white noise process with mean zero and covariance matrix † ^{2} identically and independently distributed random variables with mean zero and variance ^{2}
identically and independently normally distributed random variables with mean zero and variance ^{2} time indexed random variable realization of random variable X _{t}
spectral density
spectral distribution function periodogram transfer function of ﬁlter ‰
P _{T} X _{T}_{C}_{h}
e
P _{T} X _{T}_{C}_{h}
P fX _{t} g
WN.0; ^{2} /
WN.0; †/
IID.0; ^{2} /
IID N.0; ^{2} /
X
x
_{t}
f
_{t}
. /
/
F.
I _{T} ‰.e ^{} ^{{} ^{} /
VaR value at risk
Part I Univariate Time Series Analysis
Introduction and Basic Theoretical Concepts
1
Time series analysis is an integral part of every empirical investigation which aims at describing and modeling the evolution over time of a variable or a set of variables in a statistically coherent way. The economics of time series analysis is thus very much intermingled with macroeconomics and ﬁnance which are concerned with the construction of dynamic models. In principle, one can approach the subject from two complementary perspectives. The ﬁrst one focuses on descriptive statistics. It characterizes the empirical properties and regularities using basic statistical concepts like mean, variance, and covariance. These properties can be directly measured and estimated from the data using standard statistical tools. Thus, they summarize the external (observable) or outside characteristics of the time series. The second perspective tries to capture the internal data generating mechanism. This mechanism is usually unknown in economics as the models developed in economic theory are mostly of a qualitative nature and are usually not speciﬁc enough to single out a particular mechanism. ^{1} Thus, one has to consider some larger class of models. By far most widely used is the class of autoregressive movingaverage (ARMA) models which rely on linear stochastic difference equations with constant coefﬁcients. Of course, one wants to know how the two perspectives are related which leads to the important problem of identifying a model from the data. The observed regularities summarized in the form of descriptive statistics or as a speciﬁc model are, of course, of principal interest to economics. They can be used to test particular theories or to uncover new features. One of the main assumptions underlying time series analysis is that the regularities observed in the sample period
^{1} One prominent exception is the randomwalk hypothesis of real private consumption ﬁrst derived and analyzed by Hall (1978). This hypothesis states that the current level of private consumption should just depend on private consumption one period ago and on no other variable, in particular not on disposable income. The randomwalk property of asset prices is another very much discussed hypothesis. See Campbell et al. (1997) for a general exposition and Samuelson (1965) for a ﬁrst rigorous derivation from market efﬁciency.
© Springer International Publishing Switzerland 2016 K. Neusser, Time Series Econometrics, Springer Texts in Business and Economics, DOI 10.1007/9783319328621_1
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1 Introduction and Basic Theoretical Concepts
are not speciﬁc to that period, but can be extrapolated into the future. This leads to the issue of forecasting which is another major application of time series analysis. Although its roots lie in the natural sciences and in engineering, time series analysis, since the early contributions by Frisch (1933) and Slutzky (1937), has become an indispensable tool in empirical economics. Early applications mostly consisted in making the knowledge and methods acquired there available to economics. However, with the progression of econometrics as a separate scientiﬁc ﬁeld, more and more techniques that are speciﬁc to the characteristics of economic data have been developed. I just want to mention the analysis of univariate and multivariate integrated, respectively cointegrated time series (see Chaps. 7 and 16), the identiﬁcation of vector autoregressive (VAR) models (see Chap. 15), and the analysis of volatility of ﬁnancial market data in Chap. 8. Each of these topics alone would justify the treatment of time series analysis in economics as a separate subﬁeld.
1.1 Some Examples
Before going into more formal analysis, it is useful to examine some prototypical economic time series by plotting them against time. This simple graphical inspection already reveals some of the issues encountered in this book. One of the most popular time series is the real gross domestic product. Figure 1.1 plots the data for the U.S. from 1947 ﬁrst quarter to 2011 last quarter on logarithmic scale. Several observations are in order. First, the data at hand cover just a part of the time series. There are data available before 1947 and there will be data available after 2011. As there is no natural starting nor end point, we think of a time series as extending back into the inﬁnite past and into the inﬁnite future. Second, the observations are treated as the realizations of a random mechanism. This implies that we observe only one realization. If we could turn back time and let run history again, we would obtain a second realization. This is, of course, impossible, at least in the macroeconomics context. Thus, typically, we are faced with just one realization on which to base our analysis. However, sound statistical analysis needs many realizations. This implies that we have to make some assumption on the constancy of the random mechanism over time. This leads to the concept of stationarity which will be introduced more rigorously in the next section. Third, even a cursory look at the plot reveals that the mean of real GDP is not constant, but is upward trending. As we will see, this feature is typical of many economic time series. ^{2} The investigation into the nature of the trend and the statistical consequences thereof have been the subject of intense research over the last couple of decades. Fourth, a simple way to overcome this
^{2} See footnote 1 for some theories predicting nonstationary behavior.
1.1
Some Examples
5
problem is to take ﬁrst differences. As the data have been logged, this amounts to taking growth rates. ^{3} The corresponding plot is given in Fig. 1.2 which shows no trend anymore. Another feature often encountered in economic time series is seasonality. This issue arises, for example in the case of real GDP, because of a particular regularity within a year: the ﬁrst quarter being the quarter with the lowest values, the second
^{3} This is obtained by using the approximation ln.1 C "/ " for small " where " equals the growth rate of GDP.
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1 Introduction and Basic Theoretical Concepts
and fourth quarter those with the highest values, and the third quarter being in between. These movements are due to climatical and holiday seasonal variations within the year and are viewed to be of minor economic importance. Moreover, these seasonal variations, because of there size, hide the more important business cycle movements. It is therefore customary to work with time series which have been adjusted for seasonality before hand. Figure 1.3 shows the unadjusted and the adjusted real gross domestic product for Switzerland. The adjustment has been achieved by taking a movingaverage. This makes the time series much smoother and evens out the seasonal movements. Other typical economic time series are interest rates plotted in Fig. 1.4. Over the period considered these two variables also seem to trend. However, the nature of this trend must be different because of the theoretically binding zero lower bound. Although the relative level of the two series changes over time—at the beginning of the sample, shortterm rates are higher than longterms ones—they move more or less together. This comovement is true in particular true with respect to the medium and longterm. Other prominent time series are stock market indices. In Fig. 1.5 the Swiss Market Index (SMI) in plotted as an example. The ﬁrst panel displays the raw data on a logarithmic scale. One can clearly discern the different crises: the internet bubble in 2001 and the most recent ﬁnancial market crisis in 2008. More interesting than the index itself is the return on the index plotted in the second panel. Whereas the mean seems to stay relatively constant over time, the volatility is not: in the periods of crisis volatility is much higher. This clustering of volatility is a typical feature of ﬁnancial market data and will be analyzed in detail in Chap. 8.
1.2
Formal Deﬁnitions
7
Finally, Fig. 1.6 plots the unemployment rate for Switzerland. This is another widely discussed time series. However, the Swiss data have a particular feature in that the behavior of the series changes over time. Whereas unemployment was practically nonexistent in Switzerland up to the end of 1990’s, several policy changes (introduction of unemployment insurance, liberalization of immigration laws) led to drastic shifts. Although such dramatic structural breaks are rare, one has to be always aware of such a possibility. Reasons for breaks are policy changes and simply structural changes in the economy at large. ^{4}
1.2 Formal Deﬁnitions
The previous section attempted to give an intuitive approach of the subject. The analysis to follow necessitates, however, more precise deﬁnitions and concepts. At the heart of the exposition stands the concept of a stochastic process. For this purpose we view the observation at some time t as the realization of random variable X _{t} . In time series analysis we are, however, in general not interested in a particular point in time, but rather in a whole sequence. This leads to the following deﬁnition.
Deﬁnition 1.1. A stochastic process fX _{t} g is a family of random variables indexed by t 2 T and deﬁned on some given probability space.
^{4} Burren and Neusser (2013) investigate, for example, how systematic sectoral shifts affect volatility of real GDP growth.
1.2
Formal Deﬁnitions
9
Fig. 1.6
Unemployment rate in Switzerland
Remark 1.1. Given that T is identiﬁed with time and thus has a direction, a characteristic of time series analysis is the distinction between past, present, and future.
For technical reasons which will become clear later, we will work with T D Z, the set of integers. This choice is consistent with the use of time indices in economics as there is, usually, no natural starting point nor a foreseeable endpoint. Although models in continuous time are well established in the theoretical ﬁnance literature, we will disregard them because observations are always of a discrete nature and because models in continuous time would need substantially higher mathematical requirements.
Remark 1.2. The random variables fX _{t} g take values in a socalled state space. In the ﬁrst part of this treatise, we take as the state space the space of real numbers R and thus consider only univariate time series. In part II we extend the state space to R ^{n} and study multivariate times series. Theoretically, it is possible to consider other state spaces (for example, f0; 1g, the integers, or the complex numbers), but this will not be pursued here.
Deﬁnition 1.2. The function t ! x _{t} which assigns to each point in time t the realization of the random variable X _{t} , x _{t} , is called a realization or a trajectory of the stochastic process. We denote such a realization by f x _{t} g.
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1 Introduction and Basic Theoretical Concepts
We denominate by a time series the realization or trajectory (observations or data), or the underlying stochastic process. Usually, there is no room for misun derstandings. A trajectory therefore represents one observation of the stochastic process. Whereas in standard statistics a sample consists of several, typically, independent draws from the same distribution, a sample in time series analysis is just one trajectory. Thus, we are confronted with a situation where there is in principle just one observation. We cannot turn back the clock and get additional trajectories. The situation is even worse as we typically observe only the realizations in a particular time window. For example, we might have data on US GDP from the ﬁrst quarter 1960 up to the last quarter in 2011. But it is clear, the United States existed before 1960 and will continue to exist after 2011, so that there are in principle observations before 1960 and after 2011. In order to make a meaningful statistical analysis, it is therefore necessary to assume that the observed part of the trajectory is typical for the time series as a whole. This idea is related to the concept of stationarity which we will introduce more formally below. In addition, we want to require that the observations cover in principle all possible events. This leads to the concept of ergodicity. We avoid a formal deﬁnition of ergodicity as this would require a sizeable amount of theoretical probabilistic background material which goes beyond the scope this treatise. ^{5} An important goal of time series analysis is to build a model given the realization (data) at hand. This amounts to specify the joint distribution of some set of X _{t} ’s with
corresponding realization fx _{t} g.
Deﬁnition 1.3 (Model). A time series model or a model for the observations (data) fx _{t} g is a speciﬁcation of the joint distribution of fX _{t} g for which fx _{t} g is a realization.
The Kolmogorov existence theorem ensures that the speciﬁcation of all ﬁnite dimensional distributions is sufﬁcient to characterize the whole stochastic process (see Billingsley (1986), Brockwell and Davis (1991), or Kallenberg (2002)). Most of the time it is too involved to specify the complete distribution so that one relies on only the ﬁrst two moments. These moments are then given by the means EX _{t} , the variances V X _{t} , t 2 Z, and the covariances cov.X _{t} ; X _{s} / D E.X _{t}
EX _{t} /.X _{s} EX _{s} /D E.X _{t} X _{s} / EX _{t} EX _{s} , respectively cov.X _{t} ; X _{s} /=. ^{p} V X _{t} ^{p} V X _{s} /, t; s 2 Z. If the random
distributed then the speciﬁcation of the ﬁrst two moments is sufﬁcient to characterize
the whole distribution.
the correlations corr.X _{t} ; X _{s} /D variables are jointly normally
^{5} In the theoretical probability theory ergodicity is an important concept which asks the question under which conditions the time average of a property is equal to the corresponding ensemble average, i.e. the average over the entire state space. In particular, ergodicity ensures that the arithmetic averages over time converge to their theoretical counterparts. In Chap. 4 we allude to this principle in the estimation of the mean and the autocovariance function of a time series.
1.3 Stationarity
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Examples of Stochastic Processes
• fX _{t} g is a sequence of independently distributed random variables with values in f 1; 1g such that PŒX _{t} D 1 D PŒX _{t} D 1 D 1=2. X _{t} represents, for example, the payoff after tossing a coin: if head occurs one gets a Euro whereas if tail occurs one has to pay a Euro.
• The simple random walk fS _{t} g is deﬁned by
S t D S t 1 C X t D
t
X
iD1
X _{i}
with
t 0 and S _{0} D 0;
where fX _{t} g is the process from the example just above. In this case S _{t} is the proceeds after t rounds of coin tossing. More generally, fX _{t} g could be any sequence of identically and independently distributed random variables. Figure 1.7 shows a realization of fX _{t} g for t D 1; 2; : : : ; 100 and the corresponding random walk fS _{t} g. For more on random walks see Sect. 1.4.4 and, in particular, Chap. 7.
• The simple branching process is deﬁned through the recursion
X tC1 D
X t
X
jD1
Z _{t}_{;}_{j}
with starting value: X _{0} D x _{0} :
In this example X _{t} represents the size of a population where each member lives just one period and reproduces itself with some probability. Z _{t}_{;}_{j} thereby denotes the number of offsprings of the jth member of the population in period t. In the simplest case fZ _{t}_{;}_{j} g is nonnegative integer valued and identically and independently distributed. A realization with X _{0} D 100 and with probabilities of one third each that the member has no, one, or two offsprings is shown as an example in Fig. 1.8.
1.3
Stationarity
An important insight in time series analysis is that the realizations in different periods are related with each other. The value of GDP in some year obviously depends on the values from previous years. This temporal dependence can be represented either by an explicit model or, in a descriptive way, by covariances, respectively correlations. Because the realization of X _{t} in some year t may depend, in principle, on all past realizations X _{t} _{} _{1} ; X _{t} _{} _{2} ;::: , we do not have to specify just a ﬁnite number of covariances, but inﬁnitely many covariances. This leads to the concept of the covariance function. The covariance function is not only a tool for summarizing the statistical properties of a time series, but is also instrumental in
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1 Introduction and Basic Theoretical Concepts
Fig. 1.8
Realization of a branching process
time
the derivation of forecasts (Chap. 3), in the estimation of ARMA models, the most important class of models (Chap. 5), and in the Wold representation (Sect. 3.2 in Chap. 3). It is therefore of utmost importance to get a thorough understanding of the meaning and properties of the covariance function.
1.3 Stationarity
13
Deﬁnition 1.4 (Autocovariance Function). Let fX _{t} g be a stochastic process with V X _{t} < 1 for all t 2 Z then the function which assigns to any two time periods t and s, t; s 2 Z, the covariance between X _{t} and X _{s} is called the autocovariance function of fX _{t} g. The autocovariance function is denoted by _{X} .t; s/. Formally this function is given by
_{X} .t; s/ D cov.X _{t} ; X _{s} / D E Œ.X _{t} EX _{t} /.X _{s} EX _{s} / D EX _{t} X _{s} EX _{t} EX _{s} :
Remark 1.3. The acronym auto emphasizes that the covariance is computed with respect to the same variable taken at different points in time. Alternatively, one may use the term covariance function for short.
Deﬁnition 1.5 (Stationarity). A stochastic process fX _{t} g is called stationary if and only if for all integers r, s and t the following properties hold:
(i) EX _{t} D constant; (ii) V X _{t} <1;
(iii) _{X} .t; s/ D _{X} .t C r; s C r/.
Remark 1.4. Processes with these properties are often called weakly stationary, widesense stationary, covariance stationary, or second order stationary. As we will not deal with other forms of stationarity, we just speak of stationary processes, for short.
Remark 1.5. For t D s, we have _{X} .t; s/ D _{X} .t; t/ D V X _{t} which is nothing but the unconditional variance of X _{t} . Thus, if fX _{t} g is stationary _{X} .t; t/ D V X _{t} D constant.
Remark 1.6. If fX _{t} g is stationary, by setting r D s the autocovariance function becomes:
_{X} .t; s/D _{X} .t s; 0/:
Thus the covariance _{X} .t; s/ does not depend on the points in time t and s, but only on the number of periods t and s are apart from each other, i.e. from t s. For stationary processes it is therefore possible to view the autocovariance function as a function of just one argument. We denote the autocovariance function in this case by
s, i.e. _{X} .t; s/ D _{X} .s; t/,
_{X} .h/, h 2 Z. Because the covariance is symmetric in t and we have
_{X} .h/D _{X} . h/
for all integers h:
It is thus sufﬁcient to look at the autocovariance function for positive integers only, i.e. for h D 0; 1; 2; : : :. In this case we refer to h as the order of the autocovariance. For h D 0, we get the unconditional variance of X _{t} , i.e. _{X} .0/ D V X _{t} .
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1 Introduction and Basic Theoretical Concepts
In practice it is more convenient to look at the autocorrelation coefﬁcients instead of the autocovariances. The autocorrelation function (ACF) for stationary processes is deﬁned as:
_{X} .h/D ^{} _{} X ^{X} _{.}_{0}_{/} .h/ D corr.X _{t}_{C}_{h} ; X _{t} / for all integers h
where h is referred to as the order. Note that this deﬁnition is equivalent to the
ordinary correlation coefﬁcients .h/ D
_{} _{h} because stationarity implies
that V X _{t} D V X _{t} _{} _{h} so that ^{p} V X _{t} ^{p} V X _{t} _{} _{h} D V X _{t} D _{X} .0/. Most of the time it is sufﬁcient to concentrate on the ﬁrst two moments. However, there are situations where it is necessary to look at the whole distribution. This leads to the concept of strict stationarity.
Deﬁnition 1.6 (Strict Stationarity). A stochastic process is called strictly stationary
cov.X _{t} ;X _{t} _{} _{h} /
^{p} V X _{t} ^{p} V X _{t}
if 
the joint distributions of .X _{t} _{1} ;:::; X _{t} _{n} / and .X _{t} _{1} _{C}_{h} ;:::; X _{t} _{n} _{C}_{h} / are the same for all 

h 
2 Z and 
all .t _{1} ;:::; t _{n} /2 T ^{n} , n D 1; 2; : : : 
Deﬁnition 1.7 (Strict Stationarity). A stochastic process is called strictly stationary
if for all integers h and n 1 .X _{1} ;:::; X _{n} / and .X _{1}_{C}_{h} ;:::; X _{n}_{C}_{h} / have the same
distribution.
Remark 1.7. Both deﬁnitions are equivalent.
Remark 1.8. If fX _{t} g is strictly stationary then X _{t} has the same distribution for all
t (n=1). For n D 2 we have that X _{t}_{C}_{h} and X _{t} have a joint distribution which is independent of t. This implies that the covariance, if it exists, depends only on h. Thus, every strictly stationary process with V X _{t} < 1 is also stationary. ^{6} The converse is, however, not true as shown by the following example:
X t (
exponentially distributed with mean 1 (i.e. f .x/ D e ^{} ^{x} /; t unevenI
N.1; 1/;
t evenI
whereby the X _{t} ’s are independently distributed. In this example we have:
• EX _{t} D1
• _{X} .0/ D 1 and _{X} .h/ D 0 for h ¤ 0
Thus fX _{t} g is stationary, but not strictly stationary, because the distribution changes depending on whether t is even or uneven.
^{6} An example of a process which is strictly stationary, but not stationary, is given by the IGARCH process (see Sect. 8.1.4). This process is strictly stationary with inﬁnite variance.
1.4
Construction of Stochastic Processes
15
Deﬁnition 1.8 (Gaussian Process). A stochastic process fX _{t} g is called a Gaussian
.t _{1} ;:::; t _{n} / 2 T ^{n} ,
n D 1; 2; : : :, are multivariate normally distributed.
process if all ﬁnite dimensional distributions .X _{t} _{1} ;:::; X _{t} _{n} / with
all
n; h; t _{1} ;:::; t _{n} , .X _{t} _{1} ;:::; X _{t} _{n} / and .X _{t} _{1} _{C}_{h} ;:::; X _{t} _{n} _{C}_{h} / have the same mean and the
Remark 1.9. A
Gaussian
process
is
obviously
strictly
stationary.
For
same covariance matrix.
At this point we will not delve into the relation between stationarity, strict stationarity and Gaussian processes, rather some of these issues will be further discussed in Chap. 8.
1.4 Construction of Stochastic Processes
One important notion in time series analysis is to build up more complicated process from simple ones. The simplest building block is a process with zero autocorrelation called a white noise process which is introduced below. Taking movingaverages from this process or using it in a recursion gives rise to more sophisticated process with more elaborated autocovariance functions. Slutzky (1937) ﬁrst introduced the idea that movingaverages of simple processes can generate time series whose motion resembles business cycle ﬂuctuations.
1.4.1 White Noise
The simplest building block is a process with zero autocorrelation called a white noise process.
Deﬁnition 1.9 (White Noise). A stationary process fZ _{t} g is called a white noise process if fZ _{t} g satisﬁes:
• EZ _{t} D 0
• _{Z} .h/D ( ^{} ^{2} ^{h}
0
^{D} ^{0}^{I}
h ¤ 0:
We denote this by Z _{t} WN.0; ^{2} /.
The white noise process is therefore stationary and temporally uncorrelated, i.e. the ACF is always equal to zero, except for h D 0 where it is equal to one. As the ACF possesses no structure, it is impossible to draw inferences from past observations to its future development, at least in a least square setting with linear forecasting functions (see Chap. 3). Therefore one can say that a white noise process has no memory.
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1 Introduction and Basic Theoretical Concepts
If fZ _{t} g is not only temporally uncorrelated, but also independently and identically distributed, we write Z _{t} IID.0; ^{2} /. If in addition Z _{t} is normally distributed, we write Z _{t} IIN.0; ^{2} /. An IID.0; ^{2} / process is always a white noise process. The converse is, however, not true as will be shown in Chap. 8.
1.4.2 Construction of Stochastic Processes: Some Examples
We will now illustrate how complex stationary processes can be constructed by manipulating of a white noise process. In Table 1.1 we report in column 2 the ﬁrst 6 realizations of a white noise process fZ _{t} g. Figure 1.9a plots the ﬁrst 100
observations. We can now construct a new process fX
averages over adjacent periods. More speciﬁcally, we take X _{t}
gD 0:8718 C
0:9 0:2590 D 0:6387. ^{7} The realization in period 3 is fx
0:9 0:8718 D 1:5726, and so on. The resulting realizations of fX
t D 2;:::; 6 are reported in the third column of Table 1.1 and the plot is shown in
Fig. 1.9b. On can see that the averaging makes the series more smooth. In Sect. 1.4.3
we will provide a more detailed analysis of this movingaverage process.
g for
t D 2; 3; : : :. Thus, the realization of fX
D Z _{t} C 0:9Z _{t} _{} _{1} ,
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