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# Cointegration and Error Correction

## Another Model of Causality

Jamie Monogan

University of Georgia

## March 27, 2018

Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 1 / 20
Objectives

## By the end of this meeting, participants should be able to:

Test for cointegration among series.
Estimate a two-step or one-step error correction model.
Describe the controversies around error correction models for
potentially spurious inference.

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Long and Short Rates Again

## Does ∆Primet−1 →Tbill-Ratet ? That is, do short-term rates cause

long-term rates?
By Granger test, no.
But rational expectations implies that a change in the prime would be
expected at t-1, and therefore already incorporated in the Tbillt−1
Thus, Tbillt =f(∆Primet ), i.e., contemporaneous causality.

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Long and Short Rates Again

## Long and Short Rates Logged

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Long and Short Rates Again

Review

## Assume that both series are ARIMA(0,1,0)

Abbreviated “I(1)” in the literature on unit root econometrics.
How do we observe pre-whitened cross correlations?
Then, as you have seen before, there is no evidence of causal flow in
the CCF.
The baby and bathwater question: What if eliminating the integration
in both series also eliminated the causation between them?
There is no possible answer to this question in the Box-Jenkins
tradition because the mathematics are appropriate only for stationary
series.

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Long and Short Rates Again

Targeting

## For stationary series we have the concept of equilibrium, the level to

which the series tends to return when disturbed.
We have assumed that integrated series have no equilibrium. That
isn’t quite right. Really they have no fixed equilibrium.
Now generalize that for integrated series into a moving equilibrium, a
set of values determined by some x.
Again, this represents the level to which the series tends to return when
disturbed. It just isn’t constant.
We will say that x sets a target level for y.

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Long and Short Rates Again

Example

## Tbillst = f(Primet )+ errort

(And we could solve for that moving equilibrium level with a regression,
called a cointegrating regression.)
Then Tbillst = Tbill-equilibriumt + errort
Where Tbill-equilibriumt is a function of the prime rate,
and errort is understood to encapsulate short-term influences other
than the equilibrium level.

Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 7 / 20
Long and Short Rates Again

Intuition

## Imagine that some x sets a target level for some y, e.g.,

approval=f(economy) or Tbills=f(Prime)
But there is no causality of the asymmetric (Granger) type.
How could we tell the difference between (a) causal, and (b) spurious
association?
Contemporaneous correlation still provides no evidence of causality.
So what else?

Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 8 / 20
Cointegration Models

Assume that y is a stationary series. That is, it tends to equilibrate to
a fixed mean when disturbed.
Now three cases for a particular yt
1 yt above equilibrium
2 yt at equilibrium
3 yt below equilibrium
What do we expect of the change at t+1, ∆yt+1 ?
Thus we can write ∆yt+1 = βyt + t . If y is stationary, then our
estimated β will always be negative.
(Think: How will y respond in each of the three cases?)
So a negative β in a setup like this is evidence for stationarity as
opposed to a unit root.
What would we expect for a nonstationary series?
Trend: A non-zero α term here: ∆yt = α + t .
(Because yt = η + αt + νt .)
Unit root: A zero β term here: ∆yt = βyt + t .
(Because yt = yt−1 + t .)
Dickey-Fuller and KPSS tests can evaluate nonstationarity.
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 9 / 20
Cointegration Models

Cointegration
Engle and Granger 1987

## A relationship is said to be cointegrated (first order) if

Y is I(1)
X is I(1)
Z, the residual of y on x, is I(0)
Cointegrated processes are modelled as error corrections
But the error correction formulation is more general and can be used
also for stationary processes.

## Clive Granger on Granger Causality

“Causality of the cointegration type will not be captured by a
Granger test, which therefore should not be regarded as generally
appropriate” (Engle and Granger 1987).
This is a Type II error situation.
If you find causality with a Granger test, it is real.
But if you fail to find it, causality of the cointegration type might still
exist.
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 10 / 20
Cointegration Models Engle-Granger Two-Step

## (step 1) regress y on x (in levels) to obtain the “cointegrating vector”

– the predicted equilibrium relationship
From (1) zt = yt - βxt (“error”)
This is not suitable for causal inference, but a necessary requisite. If
and only if zt is stationary, we can proceed to step 2:
(If zt is not stationary, then the x → y relationship is spurious, not
cointegrating.)
(step 2) ∆yt = β0 +α ∆xt + πzt−1 +et

Interpretation
Coefficient on ∆xt will tap Granger causality.
A negative coefficient on zt−1 will be error correction.
Either is indicative of causality.

Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 11 / 20
Cointegration Models Engle-Granger Two-Step

Software

R
model.1 < −lm(y∼x)
model.1\$residuals
adf.test(model.1\$residuals, k=0) (to demonstrate no unit root)
model.2 < −lm(d.y∼d.x+l.z, data=yourCreation) (You must take
differences and lags, then put them in a ts.union)

Stata
reg y x
predict z,r
dfuller z (to demonstrate no unit root)
reg d.y d.x l.z

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Cointegration Models Single Equation Error Correction

## Single Equation Error Correction

Estimate:
∆yt = β0 + β1 yt−1 + β2 xt−1 + β3 ∆xt + et
Notice that x appears both as a level, xt−1 , and as a first difference,
∆xt
rearrange:
∆yt = β0 + β3 ∆xt + β1 yt−1 + β2 xt−1 + et
∆yt = β0 + β3 ∆xt + β1 (yt−1 + (β2 /β1 )xt−1 ) + et
Changing notation, β3 = α and π = β1 , we are back to the E/G
two-step model. (Though our coefficient on xt will be transformed.)
∆yt = β0 +α ∆xt + πzt−1 +et

## Interpretation of the Single Equation Model

A negative coefficient on yt−1 is evidence of error correction.
The coefficient on ∆xt tests causation of the Granger type.
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Error Correction for Stationary Series: From ADL to ECM Derivation

## It turns out that equivalent information can be found in an ADL(1,1)

to an error correction model. BEWARE of how you interpret one
model or the other, though.
The autoregressive distributed lag (ADL) model simply takes the LDV
specification in 1:

yt = α0 + α1 yt−1 + β0 xt + et (1)
and adds a term for xt−1 .
Since yt = f(xt ), adding the t-1 term simply relaxes assumptions
wherever LDV is appropriate.

## yt = α0 + α1 yt−1 + β0 xt + β1 xt−1 + et (2)

where et is white noise and |α1 | < 1.
Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 14 / 20
Error Correction for Stationary Series: From ADL to ECM Derivation

## Software for the Single-Equation ECM

R
lm(d.y∼l.y+l.x+d.x, data=yourCreation)
This assumes you have created a ts.union with differences and lags.

Stata
reg d.y l.y x d.x

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Error Correction for Stationary Series: From ADL to ECM Derivation

yt = α0 + α1 yt−1 + β0 xt + β1 xt−1 + et .

## yt − yt−1 = α0 + α1 yt−1 − yt−1 + β0 xt + β1 xt−1 + et .

3 Then add β0 xt−1 and −β0 xt−1 to the right hand side:

## yt − yt−1 = α0 + α1 yt−1 − yt−1 + β0 xt + β1 xt−1 + β0 xt−1 − β0 xt−1 + et

rearrange terms
yt − yt−1 = α0 + α1 yt−1 − yt−1 + β0 xt − β0 xt−1 + β1 xt−1 + β0 xt−1 + et
∆yt = α0 + (α1 − 1)yt−1 + β0 (xt − xt−1 ) + (β1 + β0 )xt−1 + et .

Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 16 / 20
Error Correction for Stationary Series: From ADL to ECM Derivation

## (α1 − 1)xt−1 − (α1 − 1)xt−1 + et

5 We can rewrite this equation as the Generalized ECM:

## where γ = (α1 − 1), λ1 = β0 , and λ2 = β1 + β0 + α1 − 1.

Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 17 / 20
Error Correction for Stationary Series: From ADL to ECM Derivation

Do This Wrong and You Could Report Spurious Results

## Enns, Peter K., Nathan J. Kelly, Takaaki Masaki, and Patrick C.

Wohlfarth. “Don’t Jettison the General Error Correction Model Just
Yet: A Practical Guide to Avoiding Spurious Regression with the
GECM.” Research and Politics 3(2):1-16.
Grant, Taylor and Matthew Lebo. 2016. “Error Correction Methods
with Political Time Series.” Political Analysis 24(1):3-30.

Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 18 / 20
Other Approaches

## In these notes, I have focused on a one-way ECM. My assumption is

that we theoretically believe x is exogenous, and y is endogenous.
Hence, this is a one-way process.
Time Series Analysis for the Social Sciences, however, allows that you
may believe reciprocal causation is present. In this way, you can
estimate two equations in reduced form. The India-Pakistan defense
spending example illustrates this.
Consider the Miller’s example of the drunkard and puppy.
The one-way ECM assumes the puppy is on a leash, so its movement
depends on the drunkard but not the reverse.
The two-way ECM assumes the puppy and the drunkard both call each
other and move in response to the other.
They also note than Johansen’s VAR approach would call on
estimating a VAR model and testing for implied restrictions.
This approach more naturally lends itself to multivariate situations.

Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 19 / 20
Homework

## For Next Time

Examine the data on short and long term interest rates (RATES.DTA).
For this exercise, consider a one-way ECM in which treasury bonds
(long-term interest rates, tbonds) are a function of prime rates
(short-term interest rates, prime).
Follow the two-step procedure for estimating an error correction
model:
Are the separate series integrated?
What is the result of the cointegrating regression?
Are the residuals stationary?
What is the result of your second-step error correction model?
Estimate a single-equation error correction model as well.
For your own papers: Present a table of a preliminary model.
Reading: Event History Modeling, Chapters 1-4.

Jamie Monogan (UGA) Cointegration and Error Correction March 27, 2018 20 / 20